March 16 (Bloomberg) -- Goldman Sachs Group Inc. should be prohibited from boosting its dividend or repurchasing stock because Federal Reserve stress tests showed the investment bank is too leveraged, according to former regulator Sheila Bair.
The leverage ratios of four financial firms dropped below 4 percent under the stressed scenario, according to test results the Fed released this week. Two of those firms, Citigroup Inc. and MetLife Inc., were prohibited from raising dividends or repurchasing shares. The central bank approved the capital plans of two others, Goldman Sachs and Morgan Stanley.
“No distribution should have been approved that would bring the leverage ratio below 4 percent,” Bair, the former chairman of the Federal Deposit Insurance Corp., said yesterday in an interview. “With leverage of 25-to-1, during a crisis, these banks would likely suffer a run.”
Bair, before leaving the FDIC in July, fought for the leverage ratio to be more central in U.S. and international bank regulations. Even though her ideas were accepted initially at the Basel Committee on Banking Supervision, the European Union has since balked at implementing a leverage ratio in addition to other capital requirements.
The leverage ratio caps bank borrowing based on total assets on the balance sheet, ignoring the riskiness of different holdings. When a bank is highly leveraged, a small change in asset prices is enough to wipe out capital, making it insolvent.
The Fed set a leverage ratio of 3 percent, the minimum required by U.S. law, as the threshold for 15 of the 19 banks that underwent stress tests. Goldman Sachs, Morgan Stanley and Citigroup were in the 3 percent group. MetLife, the largest U.S. life insurer and owner of a banking operation, was in the 4 percent group. All of the firms are based in New York.
Bear Stearns Cos. and Lehman Brothers Holdings Inc. both had capital ratios that met regulatory requirements, based on their risk-weighted assets, just before they collapsed in 2008. Their simple leverage exceeded 33-to-1, or was below 3 percent.
The two investment banks faced a run from their short-term creditors who refused to renew overnight or weekly loans when concern about the value of their assets mounted. Investors focus on the leverage ratio, not-risk-based capital measures, during market turmoil, Bair said.
“This underscores another weakness of the tests: They didn’t really stress liquidity,” said Bair, now a senior adviser at Pew Charitable Trusts, a Washington-based nonprofit. “The investment banks are particularly vulnerable to liquidity failures because they don’t have a large, core deposit base.”
Bair had asked the Fed, in one of her last moves at the FDIC, to reject banks’ requests to distribute capital after the 2011 stress tests. The Fed didn’t heed the advice, approving dividend increases for lenders including JPMorgan Chase & Co.
The tests still were “very valuable” because they provided transparency, Bair said.
Morgan Stanley, in its capital plan to the Fed, asked only to increase the firm’s stake in a retail brokerage joint venture with Citigroup, the company said in a March 13 statement. Goldman Sachs said its plan to repurchase common stock and potentially raise the dividend was approved.
Spokesmen for Goldman Sachs and Morgan Stanley declined to respond to Bair’s comments. Barbara Hagenbaugh, a Fed spokeswoman, declined to comment on Bair’s remarks.
The two firms became bank holding companies after Lehman collapsed, giving them unlimited access to Fed funding, like commercial banks. While both companies have commercial-banking units, deposits account for less than 10 percent of their liabilities.
To contact the reporters on this story: Yalman Onaran in New York at firstname.lastname@example.org or @yalman_bn on Twitter.
To contact the editors responsible for this story: David Scheer in New York at email@example.com.