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Sheila Bair has put her finger on the fundamental weakness of this week’s stress tests with a single statement:

“No distribution should have been approved that would bring the leverage ratio below 4 percent,” Bair, the former chairman of the Federal Deposit Insurance Corp., said yesterday in an interview. “With leverage of 25-to-1, during a crisis, these banks would likely suffer a run.”

Essentially, the stress tests model what might happen to bank balance sheets in the event of a major crisis — one which includes a peak unemployment rate of 13 percent, a 50 percent drop in equity prices, and a 21 percent decline in housing prices. The Fed wanted to make sure that all big banks would still have a capital base of at least 5% of their assets in that scenario, which is why it barred Citigroup (C) from returning capital to shareholders. Citi comes out at 5.9% “assuming no capital actions after Q1 2012″, but that number drops to 4.9% “with all proposed capital actions through Q4 2013″.

But capital levels are only half of the equation; the other half is leverage. And look at the Tier 1 leverage ratio for the different banks under the stressed scenario, on page 27 of the PDF. Citigroup plunges from 7.0% now to just 2.9% after the stress, while Bank of America (BAC) is much more robust, dropping from 7.1% to 5.3%. And here’s the scary thing: of all the big banks, it’s the ones with investment banking arms which fare the worst. There are 19 different banks listed; seven of them end up with a leverage ratio under 5% in a stressed scenario. Citi’s one; the others include Goldman Sachs (GS) (4.5%), Morgan Stanley (MS) (4.5%) and JPMorgan Chase (JPM) (4.0%), its “fortress balance sheet” notwithstanding.

Now, picture yourself in the kind of crisis where stocks are down 50% and unemployment is up to 13%. And imagine that you discover that the counterparty you use for all your financial transactions is levered 25-to-1. You will change your counterparty. That’s known as a run on the bank, and it’s fatal.

In other words, banks don’t need to just survive the stress test; they need to be able to keep their customers in a stressed situation as well. If a bank comes near to insolvency, it will go bust, as its customers rush for the exits.

As Bair says, bank counterparties don’t look at sophisticated risk-based metrics in a crisis: they look at headline numbers like the leverage ratio.

“This underscores another weakness of the tests: They didn’t really stress liquidity,” said Bair, now a senior adviser at Pew Charitable Trusts, a Washington-based nonprofit. “The investment banks are particularly vulnerable to liquidity failures because they don’t have a large, core deposit base.”

Investment-bank counterparties can flee in a matter of hours; old-fashioned deposit runs tend to take a lot longer. Which means that investment banks should be held to a higher standard than commercial banks when it comes to the stress tests. Instead, they just need to show a liquidity ratio of more than 3%. That number’s too low.

Source: What Would Happen To Investment Banks In A Crisis?