Bank Stress Tests: A Substitute for "Mark-to-Market" Accounting?

“The FDIC Board yesterday issued a notice of proposed rulemaking that would require FDIC-insured state nonmember banks and state-chartered savings associations with more than $10 billion in total consolidated assets to conduct annual capital-adequacy stress tests. As of Sept. 30, 2011, the FDIC regulated 23 state nonmember banks with more than $10 billion in total assets. 

The Dodd-Frank Act-mandated proposal defines the term “stress test”; establishes methodologies for conducting stress tests that provide for three different sets of conditions, including baseline, adverse and severely adverse conditions; establishes the form and content of a stress-test regulatory report; and requires covered banks to publish a summary of stress-test results. 

The proposal is similar to one the Federal Reserve published in December.”  (Daily Newsbyte release of the American Bankers Association, January 18, 2012)

The commercial banking industry has not wanted to adopt “mark-to-market” accounting.  There are several reasons bankers do not want to do so, but, in my mind, the most prominent reason is that they don’t want to be accountable for taking on risk…both credit risk and interest rate risk.

Remember, I have been a banker for a large part of my professional life.   

Generally, you hear bankers complain about mark-to-market accounting after-the-fact.  That is, they complain when the value of their assets have declined.  The decline in the value of an asset has either come because the asset has “gone bad” (for whatever reason), or, because interest rates have risen and the price of a security has declined.  

In the first case, the argument forthcoming from the bankers is that either the asset needs time for the economy to recover or the asset needs time for the bank to help “work out” its problems.  In the second case, bankers argue that they will hold the asset to maturity so that no capital loss will need to be realized on the asset. 

Thus, the bankers have put on assets that have higher than average credit risk or long term assets that possess interest rate risk and have not had to account for any increase in the over all riskiness of bank assets until they either write off the asset or sell the asset for a price that is below its purchase price.

But, that can mean that there are a lot of “over-valued” assets on the books of the banks.

Because banks do not have to mark their assets to market, the banking system can have lots of “zombie” banks around, banks whose financial condition is unknown to their investors or depositors. (http://seekingalpha.com/article/319205-there-are-still-zombie-banks-around)

The presence of these banks, and not just the largest banks, can be noted in the Wall Street Journal article about Florida’s BankUnited. (http://professional.wsj.com/article/SB10001424052970203735304577167241414198390.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj) The BankUnited situation is unique in that it is a bank that was acquired by an individual, John Kanas, and a group of private-equity firms.  BankUnited was a failing bank that was purchased from the FDIC and made into a profitable organization, one that is well capitalized and growing. 

Yet, the desire was for the bank to grow more, and grow by acquisition, but this has not been possible because “other Florida banks are either too sick or too expensive…“Mr. Kanas’s team has examined more than 50 potential targets in the past few years but pulled the trigger on just one.” 

The banking system is still not healthy and when “outsiders”, like Mr. Kanas and his team, actually get to review the assets of a bank during a due diligence, they find out just how fragile the banking system is. 

The original acquisition of BankUnited was done in an assisted deal that “The FDIC estimates that the failure will ultimately cost its deposit-insurance fund $5.7 billion.”  Deals are still being made for “failed” or “troubled” banks, (there are still about 850 banks on the FDIC’s list of problem banks) but the efforts to complete them and the frustration connected with “the regulatory red tape that is increasingly gripping the industry” are costly and tiresome.

Mr. Kanas is in the process of selling BankUnited and is leaving the industry.  “’He is just tired,’ said a person who knows Mr. Kanas well.”

It seems to me that the imposition of “stress tests” on the banks with more than $10 billion in assets is a way to for the regulators to “mark-to-market” the assets of these banks!   The regulators are to see what happens to the value of the assets of a bank under “three different sets of conditions, including baseline, adverse and severely adverse conditions.”

These “stress tests” are just simulations, but, the purpose of the tests are on to determine how vulnerable banks are to changing market conditions.  In other words, are the banks sufficiently capitalized to withstand detrimental movements in financial markets.

This exercise basically “marks-to-market” the loans and securities held by a bank under different scenarios.  And, the exercise is conducted by the bank regulators and not by the banks themselves.  Furthermore, the Dodd-Frank mandate “requires covered banks to publish a summary of stress-test results.”  That is, the results of these tests cannot be hidden.

Because the commercial banks would not reveal their risk exposure voluntarily and of their own making, the regulators will now design the tests relating to the risk exposure of the banks and will force the banks to reveal the results of the tests publically.

One just wonders how long it will take for the regulators to extend these “stress tests” to all financial institutions with assets of $1.0 billion or more.  And, then...

I hope the bankers are happy with the consequences of their failure to disclose!    

"Risk-taking at banks will soon be larger than ever"

A new report has been released by the Roosevelt Institute and has been announced by ABC News:
http://abcnews.go.com/Business/economists-warn-financial-us-economy/story?id=9990828. The chief economist of this institute is the Nobel prize-winning economist Joseph Stiglitz. Also, on the panel that produced the report is Elizabeth Warren of Harvard and head of the congressional group that is overseeing the spending of the TARP funds, Simon Johnson of MIT, Robert Johnson of the United Nations Commission of Experts on Finance and Peter Boone from the Centre for Economic Performance.

A major forecast of the report is that “Risk-taking at banks will soon be larger than ever.”

I am shocked!

Aren’t you?

In my view, risk-taking at commercial banks, big commercial banks, was going strong by the summer of last year. It has grown since.

Why?

Thank you Mr. Bernanke and the Federal Reserve System!

Over the past year or so, we have seen the largest subsidization of the banking system in the history of the world!

No, I don’t mean the bailout money. I mean the money the banks have access to that costs less than 50 basis points!

There is, of course, a reason for the low interest rates. The small- and medium-sized banks in the country are is serious difficulty. See my posts, “The Struggles Continue for Commercial Banks,” http://seekingalpha.com/article/190191-the-struggles-continue-for-commercial-banks, and, “Reading Between the Lines on Bernanke’s Testimony,” http://seekingalpha.com/article/191159-reading-between-the-lines-on-bernanke-s-testimony. The concern here is that if the Fed began to remove reserves from the banking system, the great “undoing”, it would precipitate even more bank failures than are projected now, given the number of banks, 702, that are on the FDIC’s list of problem banks.

The large banks, however, the top twenty-five of which make up almost 60% of the commercial banking assets in the United States, are making out like bandits. And, why not when they can borrow for almost nothing and lend out at spreads of 350 basis points or so…risk free.

And, the dollar-trade continues to prosper internationally.

But, this is not regular bank lending, lending to businesses or consumers. Regular bank lending supports the expansion of the economy and employment of workers. That lending has been declining for months and it appears as if that lending will not pick up for many more months in the future.

The large banks were too big to fail and now the large banks produce huge profits because the Fed believes that the other 40% of the banking system is “too big” to fail.

And, what are these big banks doing?

I’m not sure that there is anyone else that knows the answer to this other than the banks themselves. I have said this over and over again beginning last summer. The big commercial banks are way beyond the regulatory system in terms of what they are doing, perhaps more so now than in normal times.

Regulation is ALWAYS behind the regulated. This is just a law of nature. The issue always is, how far behind the regulated are the regulators?

When I was in the Federal Reserve System, the estimate we used was that the Fed was about six months behind the commercial banks. The banks would try something to avoid regulations and the Fed would then have to find out what the banks were doing. Once the Fed found out they would then have to bring the “regs” up-to-date to close the loop-holes.

Last summer or so, I surmised that the commercial banks, after they had paid back the bailout money, moved ahead rapidly to take advantage of the subsidy they were receiving from the Federal Reserve in terms of exceedingly low interest rates. The subsequent profit explosion at the large banks seemed to justify my suspicions.

By the fall of 2009, I was convinced that these large banks were way ahead of the regulators in terms of what they were doing. For one, the regulators still had a financial crisis on their hands and were diverted from the “new” activity. Second, as is always the case, the politicians decided to fight the last war. Their battle cry: “We have got to stop the commercial banks from doing what they were doing.” Of course, that is why regulation is seldom very effective.

The Roosevelt Institute report calls for more financial reforms: re-regulate. Of course, Joe Stiglitz is one of the leaders in crying for new, more stringent regulation. Elizabeth Warren is there also. But, the picture I have just painted contains with it the conclusion that regulation never really is that effective because it is always behind the curve. However, if the rules and regulations are excessively restrictive then innovation and change may be delayed. (How long did it take to get the Glass-Steagall Act removed?)

In this world, the world of the Information Age, innovation and change is going to take place somewhere because, as I have said before, finance is just about 0s and 1s. (See my post “Financial Regulation is the Information Age,” http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.) My feeling is that regulation can delay but it cannot stop the changes the bankers want to make. If regulation delays the ability of commercial banks to innovate and change, the innovation and change will take place elsewhere in the world. And, funds will flow to where the innovation and change is taking place.

If the conclusion of this report is that “Risk-taking at banks will soon be larger than ever,” my question to the authors of this publication is: “Where have you been?”

Obama's Push for Bank Reform

“President Obama on Thursday will publicly propose giving bank regulators the power to limit the size of the nation’s largest banks and the scope of their risk-taking activities.” This from the New York Times (http://www.nytimes.com/2010/01/21/business/21volcker.html?hp) and from the Wall Street Journal (http://online.wsj.com/article/SB10001424052748704320104575015910344117800.html?mod=WSJ_hps_LEFTWhatsNews).

After the Tuesday victory of Scott Brown in the Massachusetts Senate race, the Obama administration seems to be going “populist” and taking on Wall Street and the bankers seems to be the way to go!

Simon Johnson, a professor at MIT, published this advice on the New Republic website this morning: “Run hard now, against the big banks. If they oppose the administration, this will make their power more blatant--and just strengthen the case for breaking them up. And if the biggest banks stay quiet, so much the better--go for even more sensible reform to constrain reckless risk-taking in the financial sector.” (See http://www.tnr.com/blog/simon-johnson/trap-their-own-design.)

This, I believe, is the wrong direction for the Obama administration to take. First of all, I believe it is incorrect. See for example my post from yesterday, “Blame the Central Bankers” (http://seekingalpha.com/article/183429-blame-the-central-bankers). Also see my post from Wednesday “Bracing for New Banking Regulations” (http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations).

Secondly, there is strong evidence that you cannot win on a “populist” platform. Arguing from the “populist” approach can vote someone out of office, but it doesn’t seem to be able to elect anyone to office.

I still believe that Al Gore had the 2000 election wrapped up until he took on the “populist” mantel during the election campaign. I can still see him overlooking the Mississippi River in Mark Twain’s childhood home town of Hannibal, Missouri. Then I heard him starting to expound on the world as a “populist” politician would. My comment to others at that time: if Gore keeps heading in this direction he has lost the election!

The same advice also comes from one of the most astute political families in America: the Clinton family. In Robert Rubin’s book “In an Uncertain World: Tough Choices from Wall Street to Washington,” Rubin presents a discussion he had with Hillary Clinton. He wanted to take a public approach to an issue that was couched in “populist” language. Rubin states that Hillary responded strongly to his ideas with the comment that one could not win elections relying on a “populist” message. Rubin, consequently, backed off this approach to presenting the matter.
And, he succeeded in getting what he was after, politically.

I believe that the approach the President is taking toward banking reform should be strongly rejected. Not only do I believe that it will not help him to get re-elected, I believe that it would be a disaster for the American financial system!