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!    

Just How Bad Off Are the Banks?

Here we are, how many years after the start of the financial crisis, and we still have questions about the status of individual banks and the banking system…in both the United States and Europe.

European banks have gone through two “stress” tests.  The United States banks have gone through their own “stress” tests.  And, still, there are questions about the solvency of individual banks and the banking system. 

Christine Lagarde, Managing Director of the International Monetary Fund, received all sorts of criticism from the remarks she made last Saturday concerning the status of the European banks and the fact that they “need urgent recapitalization.” 

Early this week we read about how various European banks are writing down the values of the distressed Greek government debt they hold.  Some banks are taking have taken a 50 percent write down while others have taken haircuts of slightly more than 20 percent.  There are no standards for taking such write downs leaving each bank to follow its own path. (http://professional.wsj.com/article/SB10001424053111904199404576540291609289616.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj)

American banks are not coming off much better.  One looks at the discounts being assessed against US banks in the stock market and the legal efforts that they face and one wonders what is real.   Are these banks really solvent?

Bank of America has become the poster-child of the mismanaged large banks in the United States.  Warren Buffett brought it some relief with his “pussy-cat” deal.  Yes, Mr. Buffett can say that he (and other wealthy people) should pay more taxes as he cuts such sweet deals with such nice tax benefits for himself.  Yet, some are taking the Buffet bailout of Bank of America as a signal that maybe a closer look needs to be given the position of Bank of America. (http://dealbook.nytimes.com/2011/08/31/buffett-investment-could-erode-confidence-in-wall-st/)

Just look at some of the numbers.  Bank of America has  stated that slightly less than 20 percent of its residential mortgage loans as either delinquent or nonperforming, a rate that is similar to that of Wells Fargo.  JPMorgan Chase has about 24 percent falling in this class while the fourth of the big four, Citigroup, has less than 14 percent. 

And, “Not only does the bank still face billions in legal settlement costs from Countrywide Financial deals, but it also has to buy back billions in faulty mortgages.  Bank of America’s questionable foreclosure practices continue to drag it down, and, in addition, it faces Securities and Exchange Commission investigations into the actions of its subsidiary, Merrill Lynch, in the lead-up to the financial crisis.”

In addition, bank profits are falling (http://www.nytimes.com/2011/08/29/business/top-banks-confront-leaner-future-by-cutting-jobs.html?_r=1&scp=1&sq=profits%20falling,%20banks%20confront%20a%20leaner%20future&st=cse) and with the Fed promise that it will keep interest rates low for the next two years, bank interest rate margins and, hence, bank profits can be expected to remain squeezed for the near term. 

And, why is the Federal Reserve keeping interest rates so low for the next twenty-four months?

One reason for keeping interest rates so low is that the Fed will continue to provide the banking system with substantial liquidity so that banks can work themselves out of their bad loan situation and that failing banks can be removed from the banking system with the least disruption possible.

Furthermore, commercial banks in both Europe and the United States are cutting back on their employment by not just thousands of people, but tens of thousands of people when all the layoffs are added together.   

We look at all this information and we wonder, “Just how bad off are the banks?”  The regulators have been working on this situation for at least three years.  And, we still have all these questions?

The only conclusion one can draw from this is that the regulators and the people “in the know” did not want us to know how bad things were.  And, they still are reluctant to let any of this information out.  Notice how upset people got when Ms. Lagarde let the “cat-out-of-the-bag” on Saturday.

So much of this dilemma goes back to the discussion about the need for financial institutions to mark their assets to market.

I know how hard this is to do in the case of some assets without active markets.  And, I know how painful this is to do “after-the-fact”, that is, after the asset values drop underwater.

But, this is a lame excuse that has been allowed to go on for too long!

If banks take risky bets on interest rate movements, they should only do so with the knowledge that if the markets move against them they will have to pay a price by marking the assets to market.  I also don’t buy the argument that they will hold the assets to maturity.  If the banks “place the bet” they must pay the consequences.

Same thing with risky assets: as banks take on more and more risky loans in an effort to “beef-up” their return on capital they are overtly exposing the bank.  Again, when the assets go south the banks need to own up to the bets they placed. 

And, if these mark-to-market efforts are done on a more timely basis then the banks will have to move to correct their asset problems earlier and they will not get into the deep “doo-doo” they now find themselves in.

Sooner or later these bank problems are going to have to be taken care of.  Stringing things out as the regulators and politicians have done only postpones the day we can move off into the future.  It is a prerequisite for finally achieving more robust economic growth. 

The fact that the problems we continue to read about still exist three years after the financial collapse took place only raises further questions and continues to add uncertainty to the economic climate.  No wonder that people are so risk averse today and only want to buy US Treasury securities or gold. (http://seekingalpha.com/article/290934-struggling-with-a-great-contraction)   

More Stress Tests Coming for the Banks of Europe

We have been given Quantitative Easing 2 (QE2) by the Federal Reserve System in the United States and now we are facing Stress Tests II (ST2) to be imposed on banking institutions in the European Union. (http://professional.wsj.com/article/SB10001424052748703994904575646903413631856.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Will we eventually be facing Financial Reform Act II (FR2) that will incorporate the next round of regulatory reforms of the financial system of the United States?

I put this new round of stress tests for banks in the same place I put QE2 and the initial Financial Reform Act of 2010 and Basel III (B3)…in the dust bin. For my comments on QE2 see http://seekingalpha.com/article/234814-the-fed-s-850-billion-bet-negative-long-term-implications; for my comments on the Financial Reform Act see http://seekingalpha.com/article/206341-the-sound-and-fury-of-banking-reform; and for my comments on B3 see http://seekingalpha.com/article/225116-basel-iii-chuckle.

Regulators and reformers (R&R) just never seem to get it right!

One reason is that they are always fighting the last war. The current popular belief amongst the R&R is that the initial stress tests in Europe did not include tests on liquidity and this element of the banking structure needs to be examined to get a real view of how much “stress” the banks can take. The R&R intend to correct this omission in the next round of stress tests.

Just two points on this. First, liquidity is a market condition and not something that exists on balance sheets. One cannot look at a balance sheet and determine how liquid markets will be. Duh!

Second, if a bank cannot raise funds in financial markets because they have bad assets, this is a solvency problem and not a liquidity problem. In addition they cannot retain funds from market savvy customers

Hugo Dixon wrote in the New York Times yesterday that the Irish banks, Allied Irish Banks and the Bank of Ireland, were “excessively dependent on wholesale money from other banks and big investors.” These monies are very interest rate sensitive and very sensitive to credit risk. Even though these banks passed the earlier stress tests, when the smell of problems arose, the wholesale money “started to flee.”

However, the problem faced by these banks was not a liquidity problem. The problem arose because the wholesale depositors were concerned over the health of the banks and this is a solvency problem.

The situation here is that the R&R can only work with historical data and, consequently, are always behind the times. Their analysis is always static. The movement of the “wholesale money” is current market information and provides a forward looking assessment of the condition of a bank or banks .

What would be desirable would be current information that was “forward looking” and more accessible to the investing public. What would be desirable would be some kind of “forward looking” market information that reflected the viewpoint of market participants that were “betting” their own money.

In a recent post I included a chart that presented market information and was very current. (See http://seekingalpha.com/article/239296-market-behavior-at-odds-with-european-bailouts-liquidity-vs-solvency.) This chart shows information on Credit Default Swap (CDS) spreads on European banks as well as on Spanish banks. One can see that the price of these CDSs began rising in late 2009 in anticipation of the sovereign debt crisis of 2010 and began rising even more dramatically before the current crisis that Europe is now facing. It seems as if some market indicator like these CDS’s could be used as an early warning signal that trouble was brewing in the financial sector of an economy or in specific banks.

Note, that the information provided by the Credit Default Swaps could be used as an early warning signal that something was wrong and this “signal” could then set off further analysis of the institution, or institutions, involved that would be conducted by the regulatory agencies.

Just such a suggestion has been made by Oliver Hart is the Andrew E. Furer Professor of Economics at Harvard University. Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago, Booth School of Business. Two references to their work are “Curbing Risk on Wall Street,” http://www.nationalaffairs.com/publications/detail/curbing-risk-on-wall-street, and “To Regulate the Finance, Try the Market,” http://experts.foreignpolicy.com/blog/5478.

To quote from the latter article: “In our mechanism, when the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI (large financial institution) to issue equity until the CDS price and risk of failure came back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.”

In the former article the authors argue that “The financial crisis of 2008 resulted from a series of misguided policies, failures of regulation, and missed signals. Unfortunately, much of the conversation about regulatory reform since has revolved around ideas that would only extend and exacerbate all three.”

The problem with implementing a plan like this is it that it causes the R&R to feel like they are losing some of their control…their power. Furthermore, many people within the R&R have little confidence in financial markets…it does not fit within their worldview. This is why I ended up a recent post with this comment: “many politicians and certain economists don’t like the market system. Market performance often contradicts the world views held by these politicians and economists. And, that makes them angry”

In conclusion, I have very little confidence in a new round of stress tests and believe that ST2 will lead to ST3…and then ST4…and eventually ST(n) where n is any number you want to give it. To me the sign that an approach is not appropriate and will not be successful over time is that people continue to use the same system and attempt to make the system tougher and tougher. Their system never works because their worldview needs to be changed.