Letting banks shed capital does not restore confidence

Once again, the Bloomberg editorial board has adopted one of your humble blogger's positions.  In this case, that the stress tests don't restore confidence in the financial system and certainly are not an excuse for letting banks shed capital.

The Federal Reserve has a number of powerful tools it can use to restore confidence in the U.S. banking system. Allowing banks to weaken their financial positions shouldn’t be one of them.

Yes, the Fed could require that the banks provide ultra transparency and disclose on an ongoing basis their current asset, liability and off balance sheet exposure details.

While this would involve giving up the Fed's monopoly on all the useful, relevant information on banks, it would restore confidence because market participants could independently assess the disclosed information.

Because of market participants' confidence in their own assessment, confidence would return to the US banking system.

On Tuesday, the Fed released the results of the toughest bank stress tests it has yet performed....  

The tests had the desired effect: Bank shares rose sharply Tuesday afternoon ....

As once again the full faith and credit of the US government was pledged to protect depositors, bond holders and equity investors from losses in the stress tested banks.

After all, how can these market participants suffer any solvency related losses after the Fed has declared these banks solvent in the event of another downturn like the current financial crisis?

Given that the Fed has a monopoly on the information needed to perform these stress tests, it and the US government take on the moral responsibility to bailout depositors, bond holders and equity investors should the Fed's analysis be wrong.

Good as the stress tests were, they don’t mean the U.S. banking system is out of the woods. 

Three major banks -- Ally Financial Inc., Citigroup Inc. and SunTrust Banks Inc. -- didn’t pass, and investors still don’t have much faith in the reported capital levels of many of the rest....

Nor will investors have faith in the reported capital levels until all the banks provide ultra transparency.

Early reports suggest that payouts at some banks could exceed already high expectations.... 

Supporters of such payouts argue that they are good for confidence because they promote the perception that the banking system is on the mend....

Please note that in the absence of ultra transparency, stress tests are all about trying to manage market participants' perception.

Investors, though, have good reason to doubt those numbers. 

In the simplest terms, a bank’s capital equals its assets minus its liabilities. In their financial statements, the banks themselves admit that the values they place on assets, such as mortgages and consumer loans, don’t reflect what those assets would fetch in the market. 

Bank of America, for example, reported that as of Dec. 31, the fair value of its loans was about $27 billion less than the value the bank gave them on its balance sheet. That’s more than 12 percent of common equity, a basic measure of capital. 

Investors’ doubts are reflected in the disparity between the market value of some banks’ shares and their book value -- that is, the amount of common equity the banks say they have. 

Even after the stress-test rally, Citigroup’s shares were trading at a discount of about 40 percent to book value, and Bank of America’s at 58 percent, according to data compiled by Bloomberg. JPMorgan’s shares traded at a 7 percent discount. In all, the market value of the country’s five largest banks falls about $160 billion short of their combined common equity.

Investors are wondering if any of these banks are actually solvent (the market value of their assets exceeds the book value of their liabilities).

Since the beginning of the financial crisis, the Fed has helped the banks to hide their losses on and off their balance sheets.  This is the goal of regulatory forbearance.

If these banks are solvent, then why is the Fed not requiring ultra transparency?

If these banks are solvent, then why have all the bank life support programs put in place since the start of the financial crisis, like zero interest rate policies, not been ended?

Given the size of the banks’ credibility gap, allowing them to pay out more than $30 billion in cash is unduly generous. It might temporarily cheer shareholders and enrich some executives, but it’s hard to imagine how it will bolster confidence or make the banking system healthier.

Some might argue that until the banks adopt ultra transparency they should not be allowed to pay dividends, buyback stock or pay cash bonuses.

After all, historically ultra transparency was the form of disclosure that a bank that could stand on its own two feet made.  It is only when a bank can stand on its own two feet that these cash payments should be allowed.