This isn't how the Fed tests banks. Photo by tunart/Getty Images.
Thursday afternoon, the Fed released the results of its Dodd-Frank Act mandated supervisory stress tests of the 31 US bank holding companies with more than $50 billion in assets in a 152-page document jam-packed with acronyms.[i] These are the tests that subject banks to hypothetical stressful scenarios and determine whether or not the Fed feels they have sufficient capital to continue lending. If they fail, the Fed forces them to raise capital, potentially diluting equity shareholders' stake. The result? All 31 passed! The reaction? Crickets. These tests just don't garner the sharp headlines they once did, when bank investors presumed dilution-or even nationalization-lurked in every shadow. Nor is there much complaining the criteria are too weak. No handwringing over potential failures preceded it. Today, the Comprehensive Capital Analysis and Review (CCAR[ii])- stress test part deux, due next week, when the Fed gives a thumbs up-or-down to banks' plans to pay dividends-gets more eyeballs. Attention shifting from the risk banks pose to their ability to reward shareholders says a lot about sentiment's evolution during this bull market.
In this year's test, the Fed applied an "extreme adverse scenario" of a -6.5% drop in GDP, a 60% decline in stocks, a 25% decline in home values and 10% unemployment. These statistics loosely resemble what 2008's financial panic caused. The Fed applied them to bank-provided data regarding how much capital-cushion against loss-they have. The Fed then applies a top-secret calculation, and if banks have more than an 8% tier 1 capital ratio[iii], the Fed nods and moves on. In 2015, the closest to failing was Goldman Sachs, which posted an 8.1% tier 1 ratio, the equivalent of a D.[iv] But since all 31 passed, no capital raising will be required. Which is highly unsurprising, as no one really thought much would be required. Let's be clear-this release generated mass boredom.
Which is pretty rational, really. We have long been skeptical of these tests' ability to foresee much. Yes, some laud them for boosting confidence back in 2009. A fair point, though it may have simply soothed the then-common fear the government was going to nationalize some big banks, signaling the close of a haphazard period of government action. Whatever explains it, that initial round arguably helped stocks. Yet, we'd suggest you shouldn't have much confidence these tests prove US banks can actually weather the downturn tested for-after all, they didn't test for the destruction of capital by FAS 157 and the government's missteps-2008's causes. Panic didn't hit when unemployment hit 10% in 2010. It hit in 2008, when mark-to-market accounting wrought havoc on their balance sheets. The Fed tests effects-not causes. Backwards!
Now, is everyone in America aware of these limitations? No. But consider: These devices, which the Fed expressly states are designed to prevent a 2008 redux, get headlines, but not huge attention. That's a stark change from the past! The early 2009 announcement the government would conduct stress tests garnered fearful anticipation. The 2009 Fed transcripts, released Wednesday, show the Fed itself had worries. At the April 28-29 meeting-days before stress test results were released-Boston Fed President Eric Rosengren said his, "primary concerns are that the reaction to the test is unpredictable." At the same meeting, Chicago Fed head Charles Evans cited concerns testing could hurt lending. The Fed skipped 2010, brought the tests back in 2011, and they generated angst. In 2012, four big banks failed the tests, and the criteria were widely criticized as weak or incomplete. When only one bank failed 2013's, critics said grading was far too easy. Last year, the shift from focusing on the supervisory part to the CCAR began, and it has continued this year.
While the supervisory results are just hitting newswires, next week's CCAR is already drawing more headlines, despite the fact there is literally no way to forecast how it will turn out, as the criteria basically amount to whether or not the Fed feels warm and fuzzy about banks' dividend plans. Citigroup CEO Michael Corbat's future allegedly hinges on passing these-itself a microcosm for this sentiment shift, considering many believe his predecessor, Vikram Pandit, was forced to resign partly because the big bank failed the 2012 stress tests. One former banker says they are too opaque. The attention is here, folks, not on meeting a quantifiable capital standard. Sentiment towards banks has gone from stressing whether they must raise capital to if they can raise dividends. We aren't at a phase when fundamentals don't matter. But the shift in attitude towards stress tests is a sign of how far sentiment has evolved.
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[i] It made us think of typing sentences like, "The Fed said all 31 BHCs-including G-SIFIs the FSOC says are TBTF-passed DFAST 2015, showing total RWA is in excess of what the Fed says is their required minimum." It's all reminiscent of Robin Williams' awesome rant regarding Richard Nixon's visit from Good Morning, Vietnam.
[ii] There is another.
[iii] Meeeeh. In writing about bank regulations and capital, jargon abounds. This just means assets easy to redeem for cash relative to the amount of loans extended. Yeah, there are some finer points, but you don't need to know them to understand what these tests aim to accomplish.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.