Far too little stress in U.S. bank reform

By Rob Cox
April 6, 2010

Improving U.S. bank regulation may call for a little more stress. The disclosure and discipline imposed by the Federal Reserve’s stress tests of big banks a year ago drew a line under the crisis. The tests separated sheep from goats and led to tens of billions of dollars of new capital being raised. It’s a shame that stress tests aren’t becoming an annual event.

The tests have been overshadowed by the Troubled Asset Relief Program. After all, that $700 billion plan to recapitalize the banking system kept institutions like Citigroup, Bank of America and Morgan Stanley from going under. But the TARP scheme was fraught with conflicts still bedeviling the debate over reform, including the problem of bankers paying themselves handsomely on the back of taxpayer bailouts. As a result, few are calling for a repeat of the TARP experience.

But the Fed’s stress tests have turned out well. The central bank-led analysis of 19 financial companies last April compared their capital strength on a consistent basis across the industry. That, in turn, led to the formation of some $185 billion of new private banking capital, priced accordingly. It also set a precedent for much-needed interagency cooperation on regulation.

Despite the success of the Supervisory Capital Assessment Program, as the scheme was called, neither of the financial reform bills wending their respective ways through the House of Representatives and the Senate argues for making stress tests an annual tradition. That’s a shame.

At their most basic, the stress tests afforded investors their first-ever convenient opportunity to judge the ability of systemically important financial firms to confront a host of adverse economic conditions. Massive financial institutions and regional banks were thrown into the mix alongside credit card issuers, auto financiers and Wall Street firms.

Their assets were judged with relative uniformity across the credit spectrum, from mortgages to credit card loans to securities books. In this way, regulators mitigated the so-called “Lake Wobegon” effect, whereby every bank evaluated in isolation comes out above average. Bank examiners made their own determinations about asset quality — avoiding over-reliance on the judgments of bank executives.

Moreover, the stress tests forced the hodgepodge of regulatory authorities, including the Fed, the Treasury, Comptroller of the Currency and others to work together and share data. When multiple examiners mark each firm’s performance against others on all manner of parameters, potential weaknesses become easier to detect.

Beyond all that, the Fed took the rare step of disclosing the findings of the stress test exercise, allowing investors to make their own judgments — and price capital according to the relative risks inherent in each bank. That, at least, was the experience last year.

Consider the sheep. Immediately following the public dissemination of the stress test results on May 7, two big banks that were told they needed to top up their capital did so in a jiffy. Morgan Stanley sold $3.5 billion of stock at a 16 percent discount to its May 6 close; and Wells Fargo issued $7.5 billion-worth at an 18 percent discount.

Now look at the goats. Regions Financial was told it needed $2.5 billion of fresh capital to shore up its finances — a third more than the Tier 1 common equity capital it already had (compared to just a 10 percent capital increase at Morgan Stanley). So Regions had to work hard for the money, issuing new shares at a 31 percent discount two weeks later.

Similarly, KeyCorp — which the tests revealed had a $1.8 billion shortfall, nearly a third of its capital — had to issue $1 billion of new common shares in June at a price 37 percent below its stock price the day before the stress test results were made public.

Mr. Market, in other words, forced companies to raise capital at prices that reflected investor perceptions of their different risk profiles and, of course, the scale of capital-raising compared to where they started.

An annual stress test for the biggest financial companies, including all bank regulators but administered by the Securities and Exchange Commission — the regulator most focused on disclosure — would give the market more of what it needs to impose this sort of discipline. That would be one way to make it less likely taxpayers end up footing the bill again.

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