Bloomberg's Jonathan Weil confirms bank book capital meaningless accounting construct

In his column on the Fed's most recent stress tests, Stress Tests Pass Fed's Flim-Flam Standards, Bloomberg's Jonathan Weil confirms

• bank book capital is a meaningless accounting construct;

• insolvent banks can continue to operate for years because of the government backstop; and

• investors believe that a bank that passes the stress tests has an implicit guarantee from the government that it will not let the bank die.

It is always nice to have independent confirmation of many of the issues that your humble blogger has discussed in the context of capital requirements, the Japanese and Swedish models for handling a bank solvency led financial crisis, and stress tests.

The most important thing to understand about the Federal Reserve’s latest stress tests is what they were not intended to do. Their purpose wasn’t to test whether the nation’s biggest banks could survive a financial blowup like that of 2008 without government assistance. 

Rather, the Fed designed its tests to measure the effects a hypothetical crisis would have on banks’ regulatory capital. 

Capital is the financial cushion a company has available to absorb future losses.

Under the current Japanese model, capital is theoretically available to absorb losses, but is not used to do so.  Rather, losses are absorbed as quickly as the bank can generate future earnings in excess of banker bonuses and dividend payments to absorb the losses.

Under the Swedish model, capital is used today to absorb the losses.

While the Fed would like for us to believe that regulatory capital is the same thing, it’s quite different. And too often it bears little resemblance to reality.

That’s why the results of the Fed’s “comprehensive capital analysis” are more about public relations and manufacturing confidence than they are about disseminating reliable information on banks’ health....

Why does capital bear little resemblance to reality?

Nobody would have seen the Fed’s exercise as credible if all 19 [banks] had gotten passes.

On the flip side, just because some banks flunked doesn’t mean the test was credible. Quite the contrary, to buy into the Fed’s conclusions, you would have to accept the theory that market values for many types of financial instruments don’t matter in a crisis. This would be foolhardy.

Bank book capital bears little resemblance to reality because the market value of the banks' assets is not taken into account.

Under the Japanese model, losses are not recognized today, but rather deferred and absorbed into future earnings.  As a result, bank book capital becomes a meaningless accounting construct.

Mr. Weil illustrates this fact:

How stressful were the Fed’s tests? ... Regions Financial Corp. (RF), which still hasn’t paid back its bailout money from the Troubled Asset Relief Program, passed. 

The footnotes to the company's latest financial statements tell the story. There, the Birmingham, Alabama-based lender disclosed that the loans on its books were worth $8.1 billion less than what its balance sheet said, as of Dec. 31. By comparison, the company’s tangible common equity, a bare-bones measure of net worth, was $7.6 billion. 

So if it weren’t for the inflated loan values, Regions’ tangible common equity would have been less than zero, with liabilities exceeding hard assets.

In the case of this bank, its book capital is meaningless as it does not represent the bank's true condition.

In addition, the definition of an insolvent bank is one where the market value of its assets is less than the book value of its liabilities.  Something that was true for this bank as of Dec 31.

As a result, this bank confirms the fact that insolvent banks can continue in operation for years because of the government backstop.

In a press release, Regions Chief Executive Officer Grayson Hall said the Fed’s capital review “demonstrates the strength of our company.” ...

The bank clearly wants to communicate that the Fed has blessed it and said there is nothing to worry about.

Now, the question is, do investors believe that the government will not let the bank die and instead will bailout the bank?  As your humble blogger has said about the stress tests, they create a moral obligation for the government to bailout bank depositors, debt holders and equity investors and protect them from any solvency issues given the bank passed the stress test.

Regions probably would have failed years ago if not for its federal backstop. Instead, it now has a stock-market value of $9.1 billion. 

Clearly the Fed wanted it to attract new investors, and those who put fresh capital into Regions this week believe the government won’t let it die. That about sums up the company’s value proposition. In other words, we’re all still on the hook.