Stress Tests Don’t Mean Banks Are OK

Mark Whitehouse writes editorials on global economics and finance for Bloomberg View. He covered economics for the Wall Street Journal and served as deputy bureau chief in London. He was previously the founding managing editor of Vedomosti, a Russian-language business daily.
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Now that the results of the Federal Reserve's latest round of bank stress tests are out, the big question is how much money the Fed will allow the banks to give back to their shareholders. Ideally, the answer would be zero.

At first glance, the nation's largest financial institutions are in pretty decent shape. Even in a worst-case scenario, in which the Dow Jones Industrial Average falls to 7,221.7, the unemployment rate shoots up to 12 percent and the U.S. economy shrinks about 5 percent, 17 of 18 banks get passing grades. For the whole group, the average Tier 1 common capital ratio -- the measure of financial strength featured in the tests -- doesn't fall below 7.4 percent, compared to a minimum requirement of 5 percent.

Capital, also known as equity, is the money that shareholders put into a bank, either by buying its newly issued stock or by allowing it to hold on to the profits it generates. In times of trouble, equity is a bank's buffer against insolvency. If the stress tests show that banks have more than enough of it to get through a deep crisis, that suggests they can afford to distribute some profits to shareholders, in the form of dividends and stock buybacks. The Fed will issue its verdict on their plans to do so next week.

Looked at another way, though, the picture isn't quite so pretty. Research by economists at the Bank of England, as well as a new book by financial economists Anat Admati and Martin Hellwig, suggests that banks' equity should equal at least 20 percent of their assets -- that is, $1 for each $5 in assets -- if they want to avoid failures. Such a simple equity ratio is far more demanding than a Tier 1 common ratio, which tends to be inflated by all kinds of complicated asset-weighting. It's a relatively foolproof indicator of how big of a loss a bank can bear.

The five largest U.S. banks are very far from having that much equity. If measured by international accounting standards, their weighted average tangible equity ratio stood at only 3.75 percent in mid-2012, according to research by Thomas Hoenig, vice president of the Federal Deposit Insurance Corp. That's less than $1 in equity for each $25 in assets. It means a drop of only 3.75 percent in the value of their assets could render them insolvent.

Given how far the country's largest banks are from being safe, it would hardly be prudent to let them give equity back to shareholders. Judging from Hoenig's data, even if the banks held on to all their earnings, it could take them anywhere from nine years (Wells Fargo) to 45 years (Citigroup) to reach a 1-to-5 tangible equity ratio.

Forbidding banks to pay dividends doesn't necessarily harm shareholders: Their money is still there, ideally being put to work. Whether the country's largest financial institutions are capable of earning a decent return on the money -- or should be broken up into smaller and potentially more profitable units -- is another question entirely.

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