Bank Stress Tests Viewed As Fed Deception By Critics

Every banker knows that public confidence in the banking industry is essential.

With the banking industry approaching a near meltdown last year, the Federal Reserve decided to conduct a series of “stress tests” on the country’s largest banks in order to restore confidence in the banking system.  After reviewing the results of the stress tests, many critics now say that the tests were a deception by the Federal Reserve designed to deceive the public into believing that the banking system is sound when, in fact, it is not.

Lending credence to the voice of skeptics is the fact that regulators, including the Federal Reserve, completely failed to anticipate the banking crisis of 2008 and didn’t react forcefully until the financial system was collapsing around them.

Gary Shilling, who remains bearish on housing and the economy, argues that the fundamentals for the banking industry remain weak in Bank Stress Tests Don’t End The Pain.

The business climate for major banks around the world has changed remarkably in just four years. Decades ago, they set off on a huge leveraging spree. Then, starting in 2007, many institutions holding bad private and sovereign assets had to be bailed out by central banks and governments to prevent a collapse of the global financial system.

Even with help from the release of reserves for bad loans, U.S. banks’ return on equity was 6.8 percent in the fourth quarter, compared with 15 percent in the pre-crisis salad days. Return on assets, which skips leverage, is 0.76 percent, down from 1.4 percent.

Banks will also be faced with low returns on their basic business as slow economic growth, falling house prices, small returns on stocks, low interest rates and a flat yield curve persist in the remaining five to seven years of global deleveraging that I foresee. Consumer loans will be repaid on balance, and record nonfinancial corporate liquidity and slow economic growth will continue to curb borrowing and mergers-and- acquisitions activity. Then there are the huge counterparty risks on derivatives and potential large further write downs of troubled assets.

Do current prices reflect the continuing deleveraging of banks, persistent slow loan growth, further write-offs of bad real estate and other assets, compressed interest-rate margins, increased capital requirements and increasingly stringent regulation? I’m not convinced they do.

Jonathan Weil argues in a Bloomberg article that Fed testing of regulatory capital has no connection to reality when it comes to big banks surviving another financial crisis since banks that failed or needed huge bailouts during the crash of 2008 were classified at the time as “well capitalized” by regulators.  Weil goes on to describe the Fed stress tests as a “joke” when they tested Regions Financial Corp which still hasn’t paid back TARP money and has a negative tangible common equity of $525 million – Class Dunce Passes Fed’s Stress Test Without a Sweat.

The most important thing to understand about the Federal Reserve’s latest stress tests is what they were not intended to do. Their purpose wasn’t to test whether the nation’s biggest banks could survive a financial blowup like that of 2008 without government assistance.

Rather, the Fed designed its tests to measure the effects a hypothetical crisis would have on banks’ regulatory capital. Capital is the financial cushion a company has available to absorb future losses. While the Fed would like for us to believe that regulatory capital is the same thing, it’s quite different. And too often it bears little resemblance to reality.

That’s why the results of the Fed’s “comprehensive capital analysis” are more about public relations and manufacturing confidence than they are about disseminating reliable information on banks’ health. Citigroup Inc. (C) was deemed well capitalized under the government’s methodology when it got bailed out in 2008. So was CIT Group Inc. when it filed for bankruptcy in 2009.

How stressful were the Fed’s tests? One anecdote stands apart: Regions Financial Corp. (RF), which still hasn’t paid back its bailout money from the Troubled Asset Relief Program, passed.

The footnotes to the company’s latest financial statements tell the story. There, the Birmingham, Alabama-based lender disclosed that the loans on its books were worth $8.1 billion less than what its balance sheet said, as of Dec. 31. By comparison, the company’s tangible common equity, a bare-bones measure of net worth, was $7.6 billion.

So if it weren’t for the inflated loan values, Regions’ tangible common equity would have been less than zero, with liabilities exceeding hard assets. In short, the test was a joke, although it had its intended effect. Shares of Regions and other large banks soared, and Regions raised $900 million selling common shares on Wednesday. The company, which hasn’t reported an annual profit since 2007, plans to use the money to help repay the $3.5 billion it got from the Treasury Department in 2008.

Regions probably would have failed years ago if not for its federal backstop. Instead, it now has a stock-market value of $9.1 billion. Clearly the Fed wanted it to attract new investors, and those who put fresh capital into Regions this week believe the government won’t let it die. That about sums up the company’s value proposition. In other words, we’re all still on the hook.

The New York Times noted numerous problems related to the Fed’s “flimsy” stress tests of the biggest banks and wonders if banks should be allowed to pay large dividends so soon after almost going under – Questions as Banks Increase Dividends.

Emboldened by the Federal Reserve’s passing grades on stress tests of banks, some of the nation’s biggest financial firms are racing to dole out billions of dollars in dividends.

Such moves deplete the capital cushions of banks, potentially making them far more vulnerable to withstanding sudden market shocks.

“It’s frankly irresponsible to allow banks to quickly empty their coffers,” said Neil Barofsky, the former inspector general for the Troubled Asset Relief Program. “They should be holding onto this money.”

Another potential problem is that stress tests might overstate the health of banks, Mr. Barofsky said.

“The Fed has essentially appeased critics and proclaimed the banks healthy without doing real due diligence,” said Anat R. Admati, a professor of finance and economics at Stanford.

“Why are we letting banks hand out dividend payments and encouraging risky behavior after they passed flimsy tests?” she said. “It’s frankly dangerous, and the Fed should not allow it.”

Rebel A. Cole, a former Fed economist and a professor of finance at DePaul University, said that the stress tests created too rosy a picture, drastically understating how a financial crisis would impact banks’ balance sheets.

Another problem with the tests, critics said, was that they underestimated the legal liabilities that might still be lurking for banks as they work through a backlog of soured mortgages.

Both the Federal Reserve and the Federal Government need the big banks and will not allow them to fail regardless of their financial condition.  The fact that virtually every bank passed the Fed’s “stress tests” should not come as a surprise to anyone.