A run on U.S. bank stocks is clearly under way.
What began as an orderly sell-off has accelerated dramatically in the last two months. The KBW Bank Index has dropped 36% this year to its lowest level in a decade.
Even more troubling to many on Wall Street is the collapse of share prices at the low end of valuations. In fact, 33 of the nation's top 100 banking and thrift companies now are trading below tangible book value, compared with just 12 at the end of the first quarter.
Certain observers view this as well-deserved punishment for bank managers who abandoned reasonable underwriting standards. That is true enough in some, but certainly not all, of the cases.
However, for banks that need capital, a rapidly declining share price creates a vicious cycle. As capital becomes more expensive, banks are less likely to raise it, but the longer they wait, the higher the risk of failure. A prolonged run on bank stocks could even escalate into a run on banks themselves if capital dries up and creates a crisis of confidence.
Can anything be done to avoid such a scenario? Yes, if we recognize that the rapid collapse of bank stocks is closely tied to newly relaxed constraints on the process of shorting stocks. In addition, regulatory and accounting issues are limiting capital infusions.
Therefore, we must take the following steps.
Bring back the uptick rule. The rule, requiring that shares be sold short only on an uptick in price, was abolished July 6, 2007, allowing shares to be sold short on top of other short sales.
Repealing this rule made share declines less orderly and allowed short-sellers to create a downward spiral at banks where capital is needed. (The more the stock goes down, the more dilutive new capital gets, and the less value there is in the shares.)
There is nothing wrong with short-selling, but it should be based on economic fundamentals and not interfere with banks' capital-raising needs.
Make exchanges ensure shares are truly borrowed. We have seen short interests in many financial companies soar to 70% or more of shares outstanding — levels that seem at odds with the number of shares available to borrow. Our view is that exchanges and clearing agents need to ensure current regulations are followed rigorously, so that shares are sold short only when they have been actually borrowed.
We applaud the Securities and Exchange Commission's recent move to limit naked short-selling, and we believe it should be extended to the entire market.
Ensure private equity can provide capital. The Federal Reserve Board's rules on letting investors acquire bank stakes above 5% but below 25% may be overly restrictive and a deterrent to much-needed capital for this sector. These long-term investors are not only an important potential source of capital, but they also can play a significant signaling role in today's market.
Private-equity firms have the resources to perform extensive due diligence on potential investments. Therefore, an investment decision by a private-equity firm can be a clear and powerful sign of confidence in the bank itself.
Let economics, not accounting, drive consolidation. The Financial Accounting Standards Board's longer-term goal to expand the use of mark-to-market accounting, and the more recent proposal to drive securitized loans back on to balance sheets, have exposed bank buyers to the risk of large valuation marks.
Healthy banks can and should play a meaningful role in fixing many of the problems at weak banks. Stronger banks should base purchase decisions on longer-term fundamental values, and they should not be deterred by accounting rules that require them to take pricing information from markets that are essentially closed.
Some banks need to fail. However, the recent collapse in bank stocks could generate many more failures than are warranted by actual financial conditions.
With a few needed changes to the system of trading bank stocks and ensuring capital flows to the sector, government officials, exchanges, and the accounting profession can help reduce the number of failures and limit the impact of the credit crunch on the overall economy.