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Bank “Stress Tests”: Cover For Too Big To Fail

By on Mar 30, 2014 | 0 comments

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Twenty-nine out of the thirty largest banks “passed” the Federal Reserve’s stress test recently.

The Fed said 29 of the 30 big banks that underwent the Dodd-Frank Act stress test would have enough capital on hand to endure a major economic downturn. Zions Bancorp was the only bank that failed to meet the 5% top-tier capital threshold.

This year’s DFAST examined how banks would hold up if a deep recession were to hit; the scenario included a sharp rise in the unemployment rate, a drop in equity prices of nearly 50%, and a decline in house prices to levels last seen in 2001.

Zions projected Tier 1 capital under the stressed scenario only reached 3.5%, falling short of the Fed’s required 5% mark. Bank of America and JPMorgan Chase were also low on Tier 1 with 6% and 6.3% respectively. Wells Fargo WFC +0.39% hit 8.2% and Citigroup reached 7% under the hypothetical scenario.

Tier 1 Capital is defined as “comparison between a banking firm’s core equity capital and total risk-weighted assets. A firm’s core equity capital is known as its Tier 1 capital and is the measure of a bank’s financial strength based on the sum of its equity capital and disclosed reserves, and sometimes non-redeemable, non-cumulative preferred stock. A firm’s risk-weighted assets include all assets that the firm holds that are systematically weighted for credit risk.” “Equity capital” is basically stock, retained earnings, and “paid-in capital” (the difference between the price of stock when issued and par value).

The concern, as set forth by the Federal Reserve, is that during an economic downturn, bank investments in debt instruments could become worthless, driving the stock price down as well as the value of other assets, to the point of the banks becoming insolvent–similar to what happened in 2008 (and many times in the past, as well). Even though Citibank did not fail a stress test, the Fed ruled that it cannot return capital to investors by an increased dividend or stock buyback until 2015, because its capital plan was rejected by the Federal Reserve and because it had a capital gap that was too high for regulators.

citi

What are the takeaways from this latest round of stress tests?

1. Too big to fail is alive and well.

In trying to ensure that banks can withstand a severe downturn, the regulators are trying to prevent future taxpayer bailouts of the large banks. Of course, the banks are difficult to contain in this regard because of the fact that there is an implicit backstop in case the banks leverage themselves too much and wind up losing a lot on sour deals. Bailouts generally set bad precedents. The best regulation is self-regulation. If the banks (and their executives) knew that they alone were on the hook to investors and depositors for their own deals, they would act accordingly. What incentive is there for a bank to act conservatively if they know the Federal Reserve will bail them out if things go south?

2. Regulators will miss a “black swan” event.

Regulators are simply trying to regulate America’s large banks in an effort to make them “strong” if another crisis hits. Of course, regulators cannot predict every crisis, or the severity thereof. As outlined above, the Fed assumed that housing prices would fall to 2001 levels in a “severe downturn.” Does anything prevent housing prices from falling further? Of course not. It’s “unlikely,” according to the Fed. But that does not mean it is impossible.

black swan

Regulators often dismiss the improbable as being impossible and are therefore unprepared for what might actually be inevitable. This type of massive event that people are not prepared for is generally called a “black swan,” after Nassim Nicholas Taleb‘s brilliant work in this area. The term “black swan” is used because it refers to the fact that since most people have only seen white swans, they assume (inductively and wrongly) that a black swan could not or does not exist. This is not the case, of course. In 2007, people did not think that Fannie Mae, Freddie Mac, or Lehman Brothers could possibly fail. They were wrong. I don’t do the theory any justice here, but I encourage everybody to read Taleb and learn from him.

3. Depositors are safe–most likely.

These stress tests have nothing to do with personal banking deposits. Each depositor is guaranteed to have their deposits protected up to $250,000 by the FDIC. It is unlikely that the FDIC (despite its shortfall) would permit a bank run on deposits. Again, though, there is a moral hazard here in connection with bailouts. In a perfect capitalist system, people would deposit their money at banks that had high reserve ratios (and solid loans with little likelihood of default) because the bank would be more stable than one without strong reserves. The FDIC, despite being something that is generally considered a positive thing for American depositors, is not much more than a “Too Big To Fail” backstop for deposits. Here’s a graph from Zero Hedge which shows a pretty big shortfall for deposits.

Deposits vs Reserves vs Derivs

The FDIC touts the fact that it has the ability to borrow from the Fed up to $500 billion in the case of a real emergency. The problem with that is that $500 billion is 5% of the total deposits in US banks.

Now, I’m not suggesting you put your money under the mattress. I’m sure that the Fed would come to the rescue if the sh*t really hit the fan when it comes to deposits in banks. My argument is that banks should not put the Federal Reserve (and Congress) in that position by taking on absurd levels of risk because they feel that a taxpayer bailout protects them.

4. The inability to pay dividends or initiate buybacks is a giant red flag.

Citigroup will not be able to increase its dividend or buy its stock back because of its stress test results. I don’t offer investment advice, ever (except you should buy one of these), but usually the inability or restriction on a company returning its capital to investors is a red flag. It’s a little different in this case, because the Federal Reserve is preventing Citigroup from returning capital to investors. Usually, when a company slashes its dividend or abruptly terminates buybacks, it’s a major problem. Keep an eye on Citigroup through this process.

Bottom line: Too Big To Fail is alive and well and the Federal Reserve is trying to make banks more resilient in case a crisis hits. In reality, though, the banks themselves know their business and to make them more resilient, Too Big To Fail needs to end. This is not an overnight process, of course. But free market consequences trump government backstops and regulations which don’t work in the end, anyway.

As always, free markets are better markets.

* * *

Several key Federal Reserve members will speak this week, including Chairman Yellen, and the markets will certainly react and over-analyze their words. The March Jobs report comes out on Friday and will likely be a market-mover as well. Analysts are looking for 206,000 jobs created, with a 0.1% down tick in the unemployment rate. Also, baseball starts this week. Does it get any better than that?

Have a great week!

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Mike hails from New York City, where he practices law. He has an interest in advancing conservative and libertarian-leaning causes, which in his view have significant overlap. Mike spent his law school years in Texas, where he was instrumental in founding a chapter of the Republican National Lawyers Association. Mike has also served as the president of an international youth organization, where he was involved in lobbying American elected officials in support of various not-for-profit philanthropic causes.

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