The Federal Reserve conducted its annual stress test of the nation’s biggest banks. Eighteen banks were tested and it was discovered they would lose close to $462 billion if the economy kicked into another recession, similar to the one from 2009. Of those 18 banks, 17 could survive a severe economic meltdown, even with those kinds of losses, according to the results.
The only bank that could potentially fall permanently would by Ally Bank. The others have enough capital at this time to pull through, albeit some better than others. Specifically, both Goldman Sachs and Morgan Stanley would fall to levels that could put them at significant risk and at least “slightly above acceptable levels”. But there’s another surprise to be found in this study – and it’s one that took a lot of folks by surprise.
Despite many of the nation’s banks’ CEOs who seem to find controversy at every turn, thereby keeping them and their banks front and center in the media, what was most surprising is that Citigroup emerged as the one bank that has weathered its own financial crises of recent years better – to the point that it was deemed best prepared to weather another recession. And it’s hard its share of tough times in front of the media spotlight; it’s just handled it better than others. Wells Fargo and Bank of America came in second and third respectively.
Oh – and did we mention the surprise finding? Blame it on all of its controversy over the past year or its loud CEO, but if you were thinking JPMorgan Chase would at least be in the top three, think again. It rests at the bottom, ahead of only Morgan Stanley and Goldman Sachs. It was also determined it would shoulder the biggest losses of all 18 banks.
For those who believed then and now that the government bailout was a waste of taxpayer dollars, the Fed says it was those bailouts that put them in a safer place today. In fact, they’re better prepared today than ever. Of course, this won’t likely bode well with many considering that the monies used were tax dollars from taxpayers who are still struggling to cover their own monthly expenses.
The report was deliberately held back on Friday until after the markets closed. The test is designed to see just how well the banks could shoulder loan and trading losses. The test, aptly named the Dodd-Frank stress test, reveals what the Fed believes would happen in the collective banking sector should we hit more economic landmines. It is designed to see how each of those 18 banks would weather the storms. There’s another part of the test that’s been concluded, but the Fed won’t release that until next week. It will provide insight into whether those same banks could afford to pay their dividends and buy back their shares.
Already there are economists and bank regulators who say these stress tests don’t go far enough and in fact, are missing one important dynamic: it doesn’t factor derivatives. Specifically, there are no considerations for how U.S. and foreign accounts treat derivatives, which are financial contracts used to bet on or hedge against various pricing rice swings – interest rates, corporate debt and the like. Remember, this is a massive market – upwards of $700 TRillion. This is also a wild card, so to speak, for banks. It’s difficult to gauge it, but it’s important nonetheless. Bankers have long since criticized U.S. reliance of our own accounting rules when factoring derivatives. Those rules allow banks to “net the derivative bets” when dealing with other banks. It eliminates, for all intents and purposes, the necessary financial statements. European rules are different, of course, and this is problematic, especially considering American rules are more lenient.
I think the gross amount that the European balance sheets use is a better measurement of derivative risk,
says Fred Cannon, who heads up research at investment bank KBW, which specializes in working with financial firms.
Do things the U.S. way and you are disguising things.
Still, the testing moves forward. The Fed conducted its testing by looking at variables such as how much each bank could stand to lose in their respective portfolios and trading manuals when faced with tough economic times. The scenario included a rise in the unemployment rate to 12%, a 50% drop in the Dow, along with a 21% drop in housing prices.
Once those calculations were made, it was then figured how much capital would be left at each bank as a percentage of its loans and investments that would still be in place. A healthy bank is one that has the capital to cover a 5% drop in its assets. Worse case scenario means the average capital ratio at the largest banks would fall to 5.6%. But the Fed said the average capital ratios of the big banks would only dip to 7.4% in its most recent stress test.
Quality and Quantity
During the announcement, Federal Reserve governor Daniel Tarullo said,
Significant increases in both the quality and quantity of bank capital during the past four years help ensure that banks can continue to lend to consumers and businesses, even in times of economic difficulty.
While understanding the numbers is a bit overwhelming, most American consumers simply want to know their financial efforts are protected. We want to know our credit card is going to give us an approval when we swipe it and we want to know our retirement funds are safe. There are no guarantees, of course, but any efforts made to test the strength of the country’s financial sector is always eagerly awaited. Next week, we should know the full picture of what these stress tests really reveal and what, if any, recommendations are made.
Do these stress tests mean anything to you? Are you more likely to sleep better because of them or do you think the “big picture” is still yet to be seen? Let us know your thoughts on this or any other breaking financial news or credit card story from this week.