The rising fear in bank stock prices signal conditions ripe for financial panic

A Wall Street Journal column discusses the relationship between investors' concerns with bank balance sheets and increased volatility in bank stock prices.

Regular readers know that the only way to restore and maintain investor confidence is to require banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this data, investors can independently assess the risk of each bank.

There are emerging signs in the stock market that the U.S. economy is about to face financial headwinds that may lead to another credit crisis and recession next year. The recent volatility in bank stocks is a signal that U.S. banks, large and small, are not as healthy as many analysts assume. 

Banking is a game of confidence. 

So if the investing public is uncertain about the health of bank balance sheets, its uncertainty can turn into fear, setting the stage for a banking panic.

That is the problem with current reporting that leaves bank balance sheets opaque and the banks themselves little more than black boxes to investors.

This dynamic has played out twice before over the past 85 years—in the Great Depression and the panic of 2008-09—with devastating consequences for the broader economy. 

Over the past three months, investor uncertainty about the soundness of bank balance sheets, manifested in the daily volatility of stock prices, is back up to levels seen historically only in advance of these two great crises.

There is no reason for this uncertainty.  After the panic of 2008-09, regulators could have required banks to provide ultra transparency (disclose on an on-going basis their current asset, liability and off-balance sheet exposure details).

The volatility of bank stock prices from one day to the next depends on investor perceptions of the riskiness of the assets held by banks. 

In tranquil times, when investors feel that bank portfolios are reasonably safe and not excessively leveraged, daily volatility is low. 

When investors are uncertain about the soundness of bank balance sheets and about the adequacy of bank capital, then daily volatility rises in bank stock prices to double or triple their normal levels.

When uncertainty turns to panic, as it did in 1929-33 and again in 2008-09, the volatility in the daily movements of bank stock prices can shoot up to seven or eight times their normal levels. 

When this occurs, the damage radiates quickly from the banks to the broader economy...

So by not requiring ultra transparency, financial regulators have been gambling with the stability of the financial system and the real economy.

From mid-August through last week, bank volatility has been over 3%. The market for bank stocks is now sending a bright red warning signal that conditions are ripe for another potentially disastrous financial panic.

This extraordinary volatility is not limited to the stocks of large banks but extends to small and midsize banks as well. 

For example, the volatilities of the daily stock returns of indices of regional and smaller bank stocks have also been hovering around 3% since mid-August, including the KBW Regional Bank Index (KRX), S&P's bank index (BIX), the Nasdaq bank stock index (IXBK), and the ABA Community Bank index (ABAQ). 

What can be done?

Simple, require banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.