Stress Tests for Underachievers
The Federal Reserve's latest round of stress tests has given U.S. banks a largely passing grade. What's troubling, though, is how close some of the biggest institutions came to failing.
For the most part, the 31 banks taking part in the tests managed to convince the Fed of two things: that they have an adequate grasp of how much capital they would need to survive a severe financial crisis, and that even after giving back billions of dollars to their shareholders in the form of dividends and stock buybacks, their stressed capital ratios wouldn't fall below the minimums set by the central bank. Just two smaller units of foreign banks -- Deutsche Bank Trust Corp. and Santander Holdings USA, Inc. -- failed the qualitative assessment, and Bank of America got a reprimand.
For all the Fed's admirable efforts to make the tests stringent, though, the exercise left ample room for doubt about the banks' health. Consider, for example, how the largest ones barely scraped by. On average, the Tier 1 common ratios of the six biggest institutions by assets exceeded the 5 percent minimum by only 1.3 percentage point, compared with 4.3 percentage points for the other 25 participants. Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley made the grade only after submitting revised capital payout plans. Here's a chart, with the participants ranked by assets:
The narrow margin of error is particularly problematic given the low bar the Fed set for passing. The minimum capital ratios -- 4 percent of total assets, and 5 percent for the risk-weighted Tier 1 common ratio -- fall far short of the levels research and experience suggest would be necessary to avoid distress. It's also hard to be sure that the banks meet even this unambitious standard: Estimating the capital ratios of the largest institutions involves millions of calculations and a lot of uncertainty.
One analysis, by the Bank for International Settlements, found that even for an identical portfolio of assets, a group of 32 banks came up with capital ratios that differed by as much as four percentage points. In real life, the differences can be even larger: In the preliminary part of this year's tests, Goldman Sachs's estimate of its stressed Tier 1 common ratio, at 12 percent, was almost 6 percentage points higher than what the Fed found using its own model.
The banks' brinkmanship illustrates a problem with the stress tests and with regulation in general: Instead of thinking about how much capital they need, executives are focused on how little they can get away with. This is unfortunate, because capital -- also known as equity -- should not be seen as a burden. It's money that banks can use to make loans, and that has the added benefit of absorbing losses. Nonetheless, banks -- particularly big ones -- often see minimizing capital as "efficient," because the leverage makes their performance look better in good times, and because debt is relatively cheap thanks to government subsidies such as access to emergency loans from the Fed and taxpayer-backed bailouts.
As long as such incentives exist, the Fed has one best option to ensure the resilience of the financial system: Set the capital bar much higher.
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