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.

Bank Stress Tests - What Took The Regulators So Long?

Treasury Secretary Timothy Geithner must be having a sense of deja vu when it comes to the stress tests that regulators are currently conducting on the 19 major banks in the U.S. Take a look at his speeches as New York Fed president from early 2005 onwards and one can't help but wonder why regulators didn't act earlier to rein in the banking sector.

Geithner didn't hold many speeches as Fed president, but when he did, from 2005 onwards, he was constantly - a bit like a Greek chorus - urging financial institutions to make sure their stress tests were based on sufficiently negative parameters (the tail risk) and that the tests were conducted across all asset classes, not just on a business by business line (contagion risk). Capital and liquidity cushions - he said time and again - should be appropriate to the most negative outcomes ("adverse scenarios where uncertainty is the highest") rather than just meet minimal regulatory standards. One presumes that if he said it publicly, he was saying something similar in private, both to his fellow regulators and the firms he oversaw.

Roll forward to 2009 and his recommendations four years ago look very much like the blue print for the Federal Reserve's stress tests - and while there's little point now in bashing the regulators - who clearly saw cause for concern even when the good times were still rolling in the credit markets - we should learn the lessons of the past and remember that leaving it to the banks, or any group of private sector agents (same would be true for energy companies or health insurers) to self-regulate and do the right thing out of enlightened self interest and an obligation to their shareholders is foolhardy and invites abuse.

There's no telling what would have happened had the Fed forced the banks in 2005 or 2006 to raise capital and liquidity cushions significantly above the regulatory requirements and conduct far more stringent stress tests. The investment banks would have remained outside this net, unless the SEC had joined in, so Bear Stearns and Lehman might still have gone under. But humans are by nature prone not to do what's best for them and easily swayed by short-term considerations. Which is why we have civil laws and which is also why regulators and politicians should not shirk their duty and institute tough rules for industries that have the power to sink our economy.