The Problem with Bank Stress Tests: Regulators

Bloomberg reported on the stress tests currently being conducted by the Fed.  As readers of this blog know, although the stress tests have not been completed, the results of these stress tests are already known.   Most, if not all, of the 19 Too Big to Fail US banks will be allowed to resume paying dividends and the global standard for acceptable capital levels will have been set.

But knowing the results gets us ahead of the story.  [emphasis added]

The banks stress-tested the performance of their loans, securities, earnings, and capital against at least three possible economic outcomes as part of a broader capital-planning exercise.

Since the banks ran the tests, why would any market participant trust the results?

... The Federal Reserve ordered the 19 largest U.S. banks to test their capital levels against a scenario of renewed recession ... “They’re essentially saying, ‘Before you start returning capital to shareholders, let’s make sure banks’ capital bases are strong enough to withstand a double-dip scenario,’ ” said Jonathan Hatcher, a credit strategist specializing in banks at New York-based Jefferies Group Inc. Regulators don’t want to see banks “come crawling back for help later,” he said.

....The Fed has told banks that it expects dividends and share buybacks to be “conservative” and allow for “significant accretion of capital,” according to a November notice. Some capital payout plans may be rejected as “inappropriate,” the notice said. 

Before capital is returned to investors wouldn't it be a good time to let the market determine if these banks are solvent (the value of their assets exceeds their liabilities)?

The review “allows our supervisors to compare the progress made by each firm in developing a rigorous internal analysis of its capital needs, with its own idiosyncratic characteristics and risks, as well as to see how the firms would fare under a standardized adverse scenario developed by our economists,” Fed Governor Daniel Tarullo said in an e-mail.

Maybe Fed Governor Tarullo forgot that the market does not care what the Fed supervisors and economists think.  They had their chance before the credit crisis to show they knew what they were doing.  They were not up to the task.

One of the lessons of the credit crisis is that investors have to do their own homework and not rely on third parties like Rating Agencies or the Fed to do their homework for them.

.... Banks will also have to consider how many faulty mortgages investors may ask them to take back into their portfolios. Standard & Poor’s Corp. estimates mortgage buybacks could cost the industry as much as $60 billion.

Can you say $1 trillion?

After all, every deal that did not have the mortgages transferred to the trustee as described in the pooling and servicing agreement is subject to being repurchased.  While the failure to convey the mortgages to the trusts might not be fraud, it looks like it violates the representation that the mortgages would be put into a trust for the investors.

In addition, as Allstate shows in its lawsuit with JP Morgan, there are also representation and warranty claims based on the difference between what the prospectus claimed was the quality of the underlying collateral and what the quality actually was.

As part of the most recent capital exam, regulators have made one of the largest data requests in Fed history, outside of normal regulatory reporting, asking banks for information about their securities, loans and other holdings. This will give the Fed the ability to check and even challenge the assumptions banks make about their portfolios.

Is it possible that the Fed has listened to your humble blogger?  Or is it just so fundamentally necessary for independently judging the results that the Fed requested asset-level data that was current at the time of the stress tests.

Of course this raises the interesting question of why does the Fed rely on the banks to run the stress tests?  Given that the Fed has the data, they could have made it available to all market participants and let all the analysts and competitors run their own stress tests.  Then, the Fed could have found out what the market's view of the solvency and capitalization of the banks is.

The tests are being overseen by a new financial-risk unit assembled by Chairman Ben S. Bernanke and Tarullo. Known as the Large Institution Supervision Coordinating Committee, or LISCC, the unit draws on the Fed’s deep bench of economists, quantitative researchers, regulatory experts and forecasters and looks at risks across the financial system.

... “The current review of firms’ capital plans is another step forward in our approach to supervision of the largest banking organizations,” Tarullo said. “It has also served as an occasion for discussion in the LISCC of the overall state of the industry and key issues faced by banking organizations.”

... The dividend increases, if they happen, will be one of the most carefully screened payouts in U.S. regulatory history, with more than 100 Fed staff working on the capital analysis of the banks.

And there is the problem with U.S. or any regulators conducting stress tests.  The Fed throws 100+ staff at bank capital analysis.  This is a fraction of what the financial markets would assign to the task.

If the current asset-level data was made available to all market participants, the number of analysts would be an order of magnitude greater.  Think of the resources that competitors would deploy in analyzing each other.

Congress is also watching. The Fed should be cautious about allowing banks to reduce their capital through dividends or stock repurchases, House Democrats, including Representative Brad Miller of North Carolina, said in a Feb. 15 letter to Bernanke. 

“We applaud your undertaking new stress tests on the banks,” the lawmakers said. “It appears doubtful, however, that the stress tests alone can resolve the uncertainty facing those banks to justify reducing their capital.”

Is it possible that Congress has also been listening to your humble blogger?  Or is it just so fundamentally necessary that Congress realizes that unless the market has current asset-level data to confirm bank solvency, there are always going to be significant doubts about the solvency of the banks.

The Fed’s involvement in decisions normally reserved for boards shows how far the Dodd-Frank Act has pushed regulators into corporate governance. 

“It is an uneasy balance between regulating an institution and running it,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics in Washington, a research firm whose clients include the nations’ biggest banks. The Fed is moving “far more assertively” on bank oversight, she said.

Actually, it is the Fed's choice not to have the banks disclose current asset-level data.  If the Fed elected to have this data disclosed, it would be regulating an institution under the FDR framework and not running it.

By keeping the data to itself, the Fed violates the FDR framework.  It is recommending a specific investment when it says that a bank is adequately capitalized.