March 14 (Bloomberg) -- The Federal Reserve has a number of powerful tools it can use to restore confidence in the U.S. banking system. Allowing banks to weaken their financial positions shouldn’t be one of them.
On Tuesday, the Fed released the results of the toughest bank stress tests it has yet performed. Designed to ensure that the largest U.S. banks can survive a severe recession and renewed housing crisis, the tests included a 52 percent drop in the stock market, a 21 percent decline in house prices and a 5 percent contraction in economic activity -- similar to what actually happened from 2007 to 2009.
The tests had the desired effect: Bank shares rose sharply Tuesday afternoon as news emerged that major institutions such as JPMorgan Chase & Co. and Bank of America Corp. had passed. The results, which the central bank laudably published in detail, show that 15 of the 19 largest U.S. banks would survive the worst-case scenario without falling below minimum capital levels set by regulators.
Good as the stress tests were, they don’t mean the U.S. banking system is out of the woods. Three major banks -- Ally Financial Inc., Citigroup Inc. and SunTrust Banks Inc. -- didn’t pass, and investors still don’t have much faith in the reported capital levels of many of the rest. If the Fed wants the positive results of the stress tests to last, it should err on the side of caution in approving banks’ plans to pay dividends and buy back shares -- moves that benefit shareholders but also deplete capital.
Early reports suggest that payouts at some banks could exceed already high expectations. JPMorgan, for example, announced a dividend and buyback plan that could cost more than $16 billion this year, compared with the $13 billion analysts had expected. In all, analysts had estimated that the five largest U.S. banks would pay out more than $30 billion this year, up from about $26 billion last year, according to Bloomberg News.
Supporters of such payouts argue that they are good for confidence because they promote the perception that the banking system is on the mend. Financial institutions, they say, have ample capital by the measures regulators follow most closely. The five largest U.S. banks have an average Tier 1 capital ratio of 12.5 percent, more than enough to meet the more stringent international standards that take effect in 2019.
Investors, though, have good reason to doubt those numbers. In the simplest terms, a bank’s capital equals its assets minus its liabilities. In their financial statements, the banks themselves admit that the values they place on assets, such as mortgages and consumer loans, don’t reflect what those assets would fetch in the market. Bank of America, for example, reported that as of Dec. 31, the fair value of its loans was about $27 billion less than the value the bank gave them on its balance sheet. That’s more than 12 percent of common equity, a basic measure of capital.
Investors’ doubts are reflected in the disparity between the market value of some banks’ shares and their book value -- that is, the amount of common equity the banks say they have. Even after the stress-test rally, Citigroup’s shares were trading at a discount of about 40 percent to book value, and Bank of America’s at 58 percent, according to data compiled by Bloomberg. JPMorgan’s shares traded at a 7 percent discount. In all, the market value of the country’s five largest banks falls about $160 billion short of their combined common equity.
Given the size of the banks’ credibility gap, allowing them to pay out more than $30 billion in cash is unduly generous. It might temporarily cheer shareholders and enrich some executives, but it’s hard to imagine how it will bolster confidence or make the banking system healthier.
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