June 30, 2017    6 minute read

US Bank Stress Test: A Sense of Deja-Vu

Pride Before the Fall    June 30, 2017    6 minute read

US Bank Stress Test: A Sense of Deja-Vu

Yesterday, Janet Yellen, the chair of the US Federal Reserve Bank, stated that as a result of the financial reforms that braced the US banking industry in the period 2007 – 2009, no new financial crisis should be expected for at least as long as she is alive (sarcastic people will quickly point to the fact that since she is 70 years old it means that no systemic crisis should be expected prior to 2020-2025). Well, when the head of the largest regulating authority in the world claims that no new financial crisis should be expected in our lifetimes, this kind of statement should immediately makes senior risk managers shiver.

Reminiscent of Ten Years Ago

If you merely turn the clock back to ten years ago, many of the systemically important banks were displaying capital ratios that complied with the minimum capital requirements and regulators in those days did not raise the alarm on the eve of the financial debacle, and still some of them went overboard and/or required a bail-out by taxpayers (i.e. Bear Stears, WaMu, AIG, Dexia, ABN AMRO, Fannie Mae and Freddie Mac, Merrill Lynch, Lehman Brothers, Fortis, Wachovia, Royal Bank of Scotland, UBS, Lloyds TSB, HBOS, etc.)

This somewhat euphoric statement was made on the back of the announcement by the Federal Reserve Bank that all 34 banks that had been subjected to a Comprehensive Capital Analysis and Review (CCAR) and a Dodd-Frank Supervisory stress testing had all passed (for the first time) the annual assessment with flying colours. Additionally, as the cherry on the pie, the FRB also approved banks’ capital plan to deplete some of their excess capital for dividend distribution and shares buy-back.

Are US Banks Now Healthy?

In practice, the FRB is of the opinion that the US banks now display “healthy” balance sheets, particularly regarding solvency. Indeed, the aggregate ratio of common equity capital to risk-weighted assets doubled from 5.5% in Q1 2009 up to 12.5% in Q4 2016 (Source: FRB) corresponding to a capital injection in the system of more than $750bn in common equity capital during the period 2009 – 2016 bringing it to $1.2trn as of Q4 2016.

These 34 banks are more than merely a representative sample of the US banking industry as they hold in aggregate more than 75% of the total assets of all US financial companies. Obviously and understandably these banks celebrate this event as a cheerful victory given that those supervisory stress tests in previous represented a tremendous strain regarding risk management resources.

Have Things Improved?

While solvency is an important criterion when assessing the resilience of a bank’s business model, history has shown that while banks have complied with minimum capitalisation ratios, they still can go bust and/or require a bail-out by taxpayers.

Yes, capital levels under Basel III (Dodd-Frank) are deemed to have been reinforced with a combination of better capital quality combined with additional capital buffers regarding higher capital ratio. The common equity Tier 1 (CET 1) capital ratio is set at minimum 4.5% with a Tier 1 capital ratio defined at 6% and a minimum total capital ratio of 8%. To that, one needs to add a capital conservation buffer of 2.5% (2019) as well as countercyclical up to 2.5%. Bear in mind there is also a leverage ratio up at 4% not to mention a supplementary leverage ratio of 3%. So, again, are all these capital ratios sufficient to warrant a bank’s resilience?

Decreasing Capital Requirements

To go back one or two centuries ago, do you know much capital had to be made up for U.S. banks? In the 1800s, the capital buffer represented more than half of a bank’s liabilities, and in the 1900s it went down to 20% – and today the minimum requirement is at barely above 10%. Granted, banks have become more reliant on customer deposits as well as capital markets for bond issuance and short-term cash from MM (money-market) funds. Also, deposit insurance has made the need for very high capital buffers less meaningful.

Some view banks just like power utilities distributing money (just like electricity) to a network of customers and having a commanding position in the economic system, therefore, warranting robust capital cushions. Additionally, given that just like power companies banks’ assets are mostly made up of long term (aka fixed) assets (maturity longer than a year) they should be more capital intensive.

Stronger Economic Conditions Have Strengthened the Banks

Now, again, no one can deny that as economic conditions in the United States have improved, banks have made sizable profits and generated stronger operating cash flow allowing them to comply with their capital requirement targets. Subsequently, there are more capital reserves available to distribute higher dividends and buy back shares to spur their share prices.

But, when leverage ratios (even though they are greater than the minimum requirement) show that total assets still represent more than ten times the size of equity, one cannot have a very loud sigh of relief, mainly because the lion share of the assets of a bank is made of long-term receivables (essentially being the loan book and the securities portfolio). As such, the key to maintaining a stable ship that has a lot of long duration assets is not only about the little shiny object in the room that capitalization ratios represent, but rather about the soundness of the business model of the bank. What are the profitability drivers at the firm level as well as across business lines? What are the underwriting standards that sanction new lending/ investments, to what extent is the reliance on short-term funding, how much increased risk exposures have been taken that do not belong to the core business of the bank?

Conclusion

Quite honestly, the external threats that affect the operating environment of the banks are so strong (banking regulation, deleveraging consumer, and fintech) that merely cutting costs and refocusing investment in combination with meeting acceptable capital requirements will not be sufficient for the banks to thrive in the future. Banks need to be agiler, and to that respect, a more resilient business model that can sail through storms is required. To put a number on this argument, by keeping into life the existing business models return on equity will fall below 10% (Source: McKinsey report) breaking even with the cost of capital, and hence will cause future investors to think twice before buying bank shares.

Bottom line, Janet Yellen while she could be satisfied that banks have passed the stress test, should be more cautious about the future and learn from the past.

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