Bank Stress Tests: Why Not Before Now?

It is amazing that Geithner’s proposal to “stress test” banks is making news as new policy. After all, regulators were supposed to be doing this all along. After the last banking crisis in the 1980s, banking regulators got the authority to anticipate capital shortfalls as well as operational deficiencies. When problems are identified regulators are supposed to mandate corrective action well before a bank is in real trouble. “Prompt corrective action” (or “PCA”) is the regulatory jargon to describe the regulatory authority that has existed for years but apparently not used recently. Geithner’s announcement that regulators are going to “stress test” banks is a nice politically correct way of saying that enforcement of safety and soundness rules is back in style and self-regulation is out.

The Federal Statutes mandating prompt corrective action and the FDIC Risk Management Manual of Examination Policies contain the authority for stress testing that banking regulators had but didn’t use.

The Federal Statute sets forth five different categories of capital adequacy beginning with “well capitalized” to “critically undercapitalized” and gives regulators discretion to determine the standards for each category. The statute provides that regulators can use subjective criteria of safety and soundness to reclassify banks regardless of the numerical calculation of capital adequacy.

Institutions that don’t meet safe and sound capital standards can be required to raise additional capital, restrict both banking and non-banking activities, stop the payment of dividends and cut senior executive compensation. Also, regulators may require divestiture of assets and subsidiaries and can force banks to fire directors and officers that the regulators decide have done a bad job.

By the way, has anyone heard of a single officer or director who has been fired at the request of the regulators? Also, during 2007 and most of 2008, how many big banks that were losing hundreds of billions of dollars were required to cut their dividends so that they didn’t pay out to shareholders capital that they would later need?

The FDIC Risk Management Manual has language stating that banks should have capital to cover market risk and future changes in value and creditworthiness of assets. In fact, the Risk Manual says that banks should be running their own risk models to make sure that they have enough capital for future contingencies and that the regulators should be examining these models and the results.

Below are a few quotes from the FDIC Risk Management Manual.

“Generally, a financial institution is expected to maintain capital commensurate with the nature and extent of risks to the institution and the ability of management to identify, measure, monitor, and control these risks.

It is important to note that what is adequate capital for safety and soundness purposes may differ significantly from minimum leverage and risk-based standards and the “Well Capitalized” and “Adequately Capitalized” definitions that are used in the PCA regulations and certain other capital-based rules. The minimums set forth in the leverage and risk-based capital standards apply to sound, well-run institutions. Most banks do, and generally are expected to, maintain capital levels above the minimums, based on the institution’s particular risk profile. In all cases, institutions should maintain capital commensurate with the level and nature of risks to which they are exposed, including the volume and severity of adversely classified assets.”

“The capital adequacy of an institution is rated based upon, but not limited to, an assessment of the following evaluation factors:

• The level and quality of capital and the overall financial condition of the institution.

• The ability of management to address emerging needs for additional capital.
• The nature, trend, and volume of problem assets, and the adequacy of allowances for loan and lease losses and other valuation reserves.
• Balance sheet composition, including the nature and amount of intangible assets, market risk, concentration risk, and risks associated with nontraditional activities.
• Risk exposure represented by off-balance sheet activities.
• The quality and strength of earnings, and the reasonableness of dividends.
• Prospects and plans for growth, as well as past experience in managing growth.
• Access to capital markets and other sources of capital, including support provided by a parent holding company.”

Hmmm…this isn’t a lot different than stress testing to make sure that capital is adequate in banks. Examining risks to make sure that there is adequate capital is, by definition, a “stress testing” exercise of future contingencies and loss scenarios.

It’s great that the Obama Administration is trying to not to perform “witch hunts” of previous government action (or inaction) and is also avoiding inflammatory partisan language. But Mr. Geithner’s announcement about stress testing banks makes me wonder what regulators were doing for the last few years. Politically correct Treasury action isn’t going to change the fact that regulators didn’t aggressively enforce capital adequacy rules and instead tried “self regulation”. But, self regulation wasn’t the law that regulators were supposed to follow and even worse if just a plain dumb idea.

I applaud Mr. Geithner’s politically correct and non-confrontational announcement restoring enforcement of established rules as a priority for regulators and am glad that he did it quickly after taking office. The economy doesn’t have a lot of time left to waste.

Comments

[Mad Hedge F...:]

There is a new proposal making the rounds for solving the financial crisis known as “desecuritization.” There are $1.4 trillion in CDO’s outstanding backed by Alt-A and subprime loans in the form of 3,700 individual securitizations. Over 68% of the loans backing these bonds are current. Mark to market rules are forcing the banks to carry this paper on their balance sheets at 50% discount. This is where the $700 billion figure for the first TARP comes from. The problem is that mark to market is a meaningless accounting fiction when there is no market. If you break up these securities and place the underlying loans back on the banks’ balance sheets, the good mortgages can be valued at 100% of face, and those behind in their payments can be discounted to maybe 70% because they are still secured by the value of the underlying homes. This would boost the value of the entire asset class assets from 50 cents to 90 cents on the dollar. Restored balance sheets would enable banks to resume lending. It sounds like a workable plan, and therefore is unlikely to ever see the light of day.

Feb 23 11:06 AM

[Tom Armistead:]

Where stress testing really got problematical was the institutions supervised by the SEC - LEH, BSC, MER, MS, GS & C. These outfits were supposed to do their own stress testing and report the results monthly. The SEC was supposed to look at it when conducting examinations.

It would appear from the results that this is another area where the SEC dropped the ball. Fortunately they are no longer on the case.

Not surprising Geithner came up with the idea of a uniform stress test administered by the government. The riskiest players were getting the most lenient supervision.

Feb 23 11:10 AM

[random walking:]

Excellent article. The "old guard" is still largely in control of the problematic areas of the financial sector. For example, C and BAC CEOs may not willingly submit to an honest stress test. They still have the MSM behind them. The economy is held hostage while the game of chicken continues.

If the titans of Wall Street lose their temper tanturm, they will take their golden chutes and blame the economic havoc they leave behind on anyone who stands in the way of returning the reins of Washingon to the financial elite.

The ones who approved funding the Iraq war, financial bail outs and guarantees totalling at least 10x the amount of the recent Obama spending plan plus a continuation of a very top heavy military budget (trillions per decade and 700 plus foreign bases), scream bloody murder that the Obama spending plan passed as if it is the end of the world.

Feb 23 12:54 PM

[Heaven, Hel...:]

Hopefully, the builders of the stress test models at these institutions will not be the same ones who built the correlation based models which failed so abysmally!

Feb 23 05:46 PM