Bank Stress Tests II - Managing Expectations

So what's the likely upshot going to be on the bank stress tests? The government will end up converting its preferred stock into common shares of several of the major banks; the New York Times' list of common tangible equity levels makes it clear that Citigroup seems a definite candidate for the regulator's "must do more" list; Goldman and JPMorgan are unlikely to be allowed to pay back their Tarp funds immediately. After all, the point of the stress tests is to ensure that major banks end up holding "additional capital to provide a buffer" in case events take a turn for the worse - and while the two banks certainly have more capital than some of the others, that presumably is what regulators mean by "buffer".

That's not the only argument that regulators can wield in the debate surrounding the repayment of Tarp money: there's also the issue of what's good for the economy as a whole. Banks are a key conduit to get credit into the hands of consumers and businesses - even more so because the credit markets remain broken. Regulators are trying to manage the transition from a system in which the unregulated securitization markets took care of a hefty chunk of credit flows to the broader economy to one that relies more on the regulated banks. And they're doing this at a time when risk appetite, while better than late last year, is still pretty shaky. Sky-rocketing corporate defaults could yet send corporate debt markets into a tailspin - markets by the way that still require a fair amount of government support - we still don't know what shape the recovery will take (W or L or U - one hopes for U but can't exclude the other two). Most tellingly, the first quarter profits in the banking sector came mostly from fixed income trading - hardly a sustainable earnings driver.

So where does that leave markets? About where they are - if regulators and the banks themselves manage the results of the stress tests and their consequences properly. Financials will continue to gyrate but we shouldn't see the kind of selloff we saw last year. Bank debt spreads and CDS remain wider than normal, and rightly so, these aren't normal times. But managing the fallout won't be an easy task. The Fed notes in its white paper that "a need for additional capital or a change in composition of capital...is not a measure of the current solvency or viability of the firm." One can only hope investors are listening.