U.S. bank stress tests aren’t stressful enough

December 1, 2011, 9:59 PM UTC

FORTUNE – During the financial crisis of 2008, it became obvious that the U.S. banking system was incapable of handling the failure of a major financial institution. The bankruptcy of Lehman Brothers nearly destroyed the global financial system, and the government’s response of shelling out billions of dollars to save the institutions was met with heavy criticism.

Since then, Congress passed banking rules to avoid a repeat of 2008. Among them, the nation’s major banks with $50 billion or more in assets are required to undergo annual tests to demonstrate they could stay afloat if the economy takes a turn for the worse. No doubt such efforts are long overdue. However, the ongoing European crisis may reveal the limits of these tests.

By next month, 31 banks must show the Federal Reserve plans for how they would withstand some pretty dire economic scenarios. They include: an 8% contraction in GDP, the Dow Jones Industrial Average collapsing to 5,700 points by the middle of next year, and an unemployment rate rising from the current 9.1% to 13% by 2013.

But it seems the test isn’t factoring in one of investors’ biggest worries: Debt defaults in the euro zone.

Other than having the six biggest banks test the scenario of “sharp market price movements in Europe sovereign and financial institutions,” the Fed doesn’t explicitly ask how lenders would fare if a country like Greece or Portugal defaults on its debts. What’s more, it doesn’t include other much talked about scenarios, including massive restructuring of sovereign debts or a catastrophic break-up of the euro zone.

“Stress tests only make sense if you put stress in the system,” says Simon Johnson, former chief economist at the International Monetary Fund. “They’re not baseline tests.” He urges for more rigorous tests.

Central banks offer aid, but not a eurozone fix

Similar issues were raised earlier this year when European banks revealed their latest stress test results. Out of the 90 banks tested, only eight flunked. Analysts and investors expected far worse, but even the better-than-expected results didn’t calm investors as many thought the tests weren’t rigorous enough, since they didn’t simulate a debt default, which many expect is inevitable in Greece.

Earlier this month, Fitch Ratings warned that U.S. banks could be “greatly affected” if Europe’s debt crisis continue to widen. The ratings agency said the six largest U.S. banks – JP Morgan Chase (JPM), Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), Goldman Sachs (GS) and Morgan Stanley (MS) – hold about $50 billion in debt from the stressed euro zone nations of Greece, Ireland, Italy, Portugal and Spain. But exposure to Europe’s bigger economies is much greater. The top five U.S. banks (leaving out Wells Fargo) have $188 billion in exposure to French banks alone and $225 billion in exposure to the UK.

Nevertheless, Fitch says the rating outlook for the U.S. banking industry is stable, reflecting improved capital and liquidity positions at most banks. But maintaining that outlook will of course depend how orderly and timely European officials resolve the euro zone’s debt crisis.

And though it seems European officials have tried to ease the crisis, the solutions have only served as temporary Band-Aids. So it’s hard not wonder if banks should be preparing for the very worst outcomes in their stress tests. Admittedly, the latest round of U.S. bank tests subject banks to even more scrutiny than in the previous two years. In tests that began in 2009, only 19 banks (those with $100 billion or more in assets) were required to participate. With the Dodd-Frank law, the scope expanded to include banks with more than $50 billion, bringing the number of banks under watch to 31.

Europe has itself to blame for bank sell-off

Even if the Fed decides to order banks to test their financial strengths in the case of a euro zone break up, that may be easier said than done, says Anil Kashyap, economics and finance professor at the University of Chicago.

“Specifying how to do a euro zone break-up analysis would be incredibly difficult,” says Kashyap, who has studied the methods of bank stress tests. There are so many uncertain legal and financial implications involved that asking banks to come up with an analysis becomes speculative at best.

And even if banks craft the most accurate analysis, the results may come too late. Though banks must file their results by January, based on this year’s exercise, results aren’t likely to be known until April. And by that time, the crisis that world leaders imagine could very well have unfolded.