Bond vigilantes should stress out US banks

A Wall Street Journal Heard on the Street column by David Reilly looks at the contortions the Fed is going through to try to restore investor confidence in banks.

Regular readers know that the only way to restore investor confidence in the banks is to require the banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this data, market participants can independently assess the risk of the banks and adjust both the amount and price of their exposures.

Instead of requiring ultra transparency, the Fed is focusing on stress tests and adopting the moral obligation to bailout investors in any bank that passes the test.  It is the moral obligation that keeps the bond vigilantes at bay.

If banks were required to provide ultra transparency, the bond vigilantes would move the banks' cost of funds to levels that reflect the risk of each bank.

Banks are notoriously complex.

Made more so by the opacity that surrounds their financial disclosure.  The Bank of England's Andy Haldane refers to banks as 'black boxes'.

But in one respect, they are pretty simple; like other companies, banks depend on access to a raw material to build products and need to purchase it at a price that allows them to generate a profit. 

For banks, that raw material is money. Whether banks can persuade credit investors to provide it comes down to confidence and capital. And as the European crisis shows, doubts on either can mean suppliers charge too high a price or simply walk away. 

That is worth remembering as the Federal Reserve prepares for another round of "stress tests" to determine whether some big U.S. firms can return capital to shareholders.... 

In doing so, the Fed will again grapple with the question of how much capital is enough. That is particularly tricky because the Fed wants banks to hold enough capital to absorb losses but also doesn't want to constrain lending and, thereby, economic growth.

As this blog has repeatedly discussed, bank capital is a meaningless, highly manipulated number.  The Fed should never look at it again.

However, because the Fed focuses on bank capital, it causes itself all sorts of problems.

And the Fed faces an added dilemma. It has decided the economy is so fragile that extraordinary monetary-policy actions are appropriate and even more may be needed. That in itself argues against banks doing anything other than stockpiling capital. 

For their part, banks argue that holding too much capital hampers credit creation. They also worry that holding more capital makes it tough to generate higher returns on equity, affecting valuations. ... 

So let's see what the Fed gets for its focus on bank capital.  It provides an incentive to banks to stop lending.

In the Eurozone where banks are being asked to achieve a 9% Tier I capital ratio, banks are dumping sovereign bonds in addition to reducing lending.  In effect, the European regulators have created a credit crisis by their focus on bank capital.

Hopefully, the Fed will learn from the European experience.

Yet any doubt about capital sufficiency means banks can lose access to funding. That, too, can have adverse economic consequences. 

In a note Friday, analysts at Morgan Stanley argued that "bank funding is as big a brake on bank lending as bank capital." Banks that can't raise funds have to shrink their balance sheets.

Who would lend to a bank when they cannot evaluate the risk of the bank?

Dexia showed that a bank can have a high Tier I capital ratio and still need to be nationalized.

The only way to restore and maintain investor confidence is by requiring banks to provide ultra transparency on an on-going basis.

So it is good the Fed's coming stress tests look stressful. ... 

But the lack of investor confidence in banks justifies a harsh approach. Of the six biggest banks, none are trading above book value, and only Wells trades above tangible book. 

Given this, the Fed needs to be mindful of credit investors. Granted, the Fed has been able to print money without bond vigilantes exacting revenge. But the vigilantes are present in bank credit markets, as Europe's institutions know. 

Even U.S. banks are feeling some heat. The price of insuring against default at the biggest institutions, for example, has jumped. ... 

Clearly, the bond vigilantes are on the prowl. The Fed shouldn't do anything that spurs them to further action.