Whatever the results of the stress test are, increasing levels of tangible common equity (TCE) should be at the heart of the response. That implies painful and dilutive capital raisings to come, and not just for the banks being tested.
U.S. regulators will next week release information about the stress tests they are holding on 19 large banks. Expectations are that a substantial number will be forced to raise new capital and that some will be guided to converting existing preferred securities into plain old equity.
Tangible common equity, the bit that takes the first loss, is the foundation of banks’ capital structure and has been sadly eroded in recent years, worn away by losses and a preference for preferred securities and other types that count towards the Tier 1 regulatory measure of capitalisation.
The TARP money, in other words, has been aimed at the wrong part of the capital structure, probably at least in part as a tactic to stave off the nationalization question.