Stress tests: The results are in, now what?
The market has anxiously waited over two months. With the stress test results in, we now have our work cut out for us. Not that these findings were surprising, as the 10 banks which made the government’s “need to raise additional capital now” list are the usual suspects, such as Bank of America (BofA), Citigroup, Wells Fargo, SunTrust, Fifth Third, KeyCorp, and Capital One. They were problem banks before the tests and they continue to be. But this painfully drawn-out process has spawned four tangible benefits worth discussing.
First, the stress test results raise an important policy question: Should our largest banks, those central to our economy, be allowed to take such large risks? These results paint a clearer picture of the level of risky lending practices that many of our 19 largest banks engaged in over the last decade. The government’s assessment provides added support to the need for re-regulation in this vital industry. In the worst-case scenario, the Fed reported that these banks, which control the majority of our country’s deposits and loans, could need to raise approximately $600 billion in additional capital just to cover increased loan defaults.
Second, the stress test results show that risky bets were not just concentrated but spread over many areas, including trading and financial contracts, first and second mortgages, commercial loans, securities, and credit cards. Having more detail on the sheer scope and size of these risky bets and potential losses provides a stronger case for the need to revamp the capital standards currently applied to banks.
It also raises the question of how the Fed and other regulators might monitor the on-going level of bank risk-taking activities. Under the existing Tier 1 regulatory capital standard, almost all 19 banks pass with flying colors, yet the stress tests show a bleaker picture as the majority failed this equally important financial health test. The level of risk they are taking, should the economy weaken further, can not be supported by their current level of capital. Tests indicate that the 10 weaker banks need to raise approximately $75 billion to cushion against those losses.
Going forward, higher regulatory capital standards should be mandated. Banks also should be discouraged from risky lending practices, and a new Glass-Steagall type act, which was unfortunately repealed in 1999, needs to be put back on the table. Doing so will help to separate higher risk-taking banks from lower risk-taking banks.
Third, the stress test results highlight the fragility of our banking industry and the need for bankers to rethink what are acceptable levels of risk taking. Not long ago, the term “stodgy” was used to describe a bank or banker. Today it’s more accurate to use “risky.”
Fundamentally, banks attempt to make money only three ways — interest loans, fee-based products and services, and proprietary trading. Each has a varying degree of risk. What makes one bank willing to take more risk than another is driven by management risk appetite, the perception of risk being taken, and the amount of capital to support such risk taking. A bank with lower capital is a boat that needs to stay close to shore. Banks with higher capital have greater ability to go out to sea, take risks, and weather a financial storm.
As expected, some bankers see an inherent conflict with large capital reserves as this can reduce their perceived returns. While bankers have no control over the economy, they have absolute control over the level of risk that they take and the capital levels they deem as adequate. Ideally, bankers should take these factors into account as they continue to recalibrate their risk-taking activities to match the level of capital needed.
Fourth, the government’s very public stress-testing blitzkrieg elevated general awareness of the benefits of using such risk-management tools in evaluating and planning around possible adverse financial outcomes. And while stress testing has been used for decades by banks and regulators, the fact that banks overdosed on risk over time and not overnight suggests that such tools were infrequently used or ignored in the pursuit of seeking excessive profits. Also, more aggressive model assumptions can and should be applied. Going forward, with elevated awareness of stress testing, bankers and regulators should increase the effective use of risk-management and planning tools in managing bank-related risk.
Some banks have a greater propensity to overdose on risk, regardless of the initial size of their boats. Many, such as BofA, Citigroup, Wells Fargo, and Capital One, are out to sea in a financial typhoon and now must be brought (or towed) back to safe harbor. Stronger capital requirements, better regulatory risk oversight, and bankers with a stronger handle on fundamental risk-management principles should help reduce the chance of another banking meltdown.