The Federal Reserve will not be releasing the results of its stress tests of the nation's biggest 19 banks until Thursday, and undoubtedly there is some element of folly in daring to beat the Fed to the punch. After all, according to The New York Times, the tests have been in the works for two months and have involved more than 150 regulators who, in addition to poring through voluminous bank data, have had the benefit of the banks' analyses of how various hypothetical situations will affect their loss rates.
Still, one can't help but wonder if there are other tools at hand that can get the job done properly without taking so long. In fact, I introduced such a tool in my last post – a bank’s asset quality (AQ) index. It enlists an engine of analysis that dwarfs even the Fed's 150 regulators -- namely the equity and debt markets. Quite simply, it compares a bank’s share of market capitalization to its share of revenues -- the interest it earns on producing assets plus fees for banking services. This provides a quick insight into how the share of value investors assign to these institutions compares with the share of revenues they earn on assets, which constitutes a direct measure of their investment quality.
When share of market capitalization exceeds share of revenues, it suggests that a bank may be holding the amount of common stock necessary to absorb future losses; when the reverse is true, it suggests that it may not. Doing the calculations doesn’t take two months and 150 regulators, although it does focus on something that the Fed defines as essential to banks' health -- the amount of capital represented by common stock.
CALCULATING YOUR BANK'S AQ
Calculating a bank’s AQ score is a simple two-step process:
Step 1 is to decide on a sample of banks: three or more banks over ten or more periods.
Step 2 is to sum their total capitalization and revenues and calculate the percentage of the total represented by each bank. Then take the difference and standardize it. Statistics 101 shows us how to do this in units called standard deviations, which are measures of how far a bank’s AQ score is from the mean. This is the bank’s AQ – Asset Quality.
Bank AQ scores above the mean are positive and those below the mean are negative. Statistics 101 also teaches us that for any Bank AQ value in this sample greater than +1.7 the chance that has troubled assets is less than 5%, whereas any value lower than -1.7 means that chance is greater than 95%.
THE GOOD BANKS
In terms of the Federal Reserve’s criterion, less than a 5% chance of holding troubled assets means it is highly likely these 40 banks have enough capital in common stocks to absorb future losses as the recession wears on.
For comparison, the April 24, 2009 DealBook story “Judgment Day for Big U.S. Banks” concluded that U.S. Bancorp (USB) and JP Morgan Chase (JPM) “probably have put the bulk their troubles behind them.” These conclusions are supported by their AQ scores of +4.15 and +1.81 respectively -- these banks almost certainly have put the bulk of their troubles behind them.
THE MIDDLE BANKS
Based on their AQI the 32 middle banks in this list had a greater than 5% but less than 95% chance of holding troubled assets in their portfolio in the last quarter of 2008.
In terms of the Federal Reserve’s criterion, the banks in this list have an increasing chance of holding troubled assets. This means it is highly likely that those banks near the top of this hold enough capital in common stocks to absorb future losses as the recession wears on. Those near the bottom of this list likely do not. Banks in the middle have around a 50/50 chance.
That DealBook story also concluded that Bank of New York Mellon (BK) and State Street Corporation (STT) probably have put the bulk of their troubles behind them. Based on their AQ both of them are on the cusp between the good and middle banks with scores of +1.66 and +1.36 respectively giving them just a 0.05 and 0.09 chance of having future troubles as the recession wears on.
THE UGLY BANKS
Based on each bank AQ the 20 institutions in the following list have a greater than 95% chance of holding a significant proportion of troubled assets on their balance sheet.
DealBook also concluded that a number of regional banks are “strong candidates for needing additional money.” The story fingered Sun Trust Banks (STI) with an AQ of -2.14 and Regions Financial Corp (RF) with an AQ of -2.93. These AQ scores are associated with a 0.98 and 0.99 chance of needing additional capital.
In the American Bankers’ list of the top 150 institutions with the most deposits, 112 were public companies. Twenty of these failed to report in one or more of the 32 quarters ending with the last quarter of 2008. The final sample of 92 “Bank and Thrift Holding Companies with the Most Deposits Q3-2008” was used in this study.
One might call this method of assessing a bank’s health no more than taking its temperature. But, even if temperature doesn't provide complete information of the health of a bank, it does sort out the ones in need of triage.
As always, your comments are welcome.