Weeks of leaks made the final test scores seem anticlimactic, to say the least, and the six-month window given to banks who need to add capital to fill the gaps reduced the impact even more. But the grades have been posted, and from the language of the press releases one would think that the D students aced their finals. Everybody gets a trophy.
As it turns out, school’s still in session to figure out what the test results will mean for the rest of the industry, and for the big banks that put their systemic risk susceptibility through the paces.
As everyone knows, the Treasury and the Federal Reserve declared that only 10 of 19 large banks had to find an additional $74.6 billion in capital to their reserves. Bank officials and analysts seemingly have those plans in motion, given they have until June 8 to announce their means to cover shortcomings, and November to implement the program.
But what the stress test results haven’t solved is how these will act as precedent to smaller institutions, and what they will prove to mean in the too-big-to-fail debate.
William Isaac, chairman of global financial services at consulting firm LECG and former chairman of the FDIC says there was “some accuracy in the results.” The idea that they assumptions are “educated guesses about the future doesn’t change the fact that they are guesses, even though they’re reasonable,” he adds. Isaac finds it “odd that the exercise was done in public.” This breach of confidentiality was “very unhealthy, and should not have been done.’” All the publicity didn’t yield anything positive, he argues: “We’re right back where we started—the very people who’ve been yelling the banks are undercapitalized are still yelling.”
Even worse, regulators continue to use “highly pro-cyclical, mark-to-market accounting” in measuring the health of these institutions, according to Isaac. “Basel capitalization rules use models that look backward, that say in good times banks don’t need so much capital. We really need counter-cyclical rules that help strengthen banks in bad times.”
Alex Pollock, an American Enterprise Institute scholar and former president and CEO of the Federal Home Bank of Chicago, downplayed the importance of the test’s assumptions, since “it will be two years before you see if they’re right.” The stress test extravaganza was “supremely good political theater,” says Pollock. “Act One poses the question, are the banks broke? In Act Two, the suspense builds. And Act Three brings the happy ending.” Timing has a lot to do with the successful outcome: “They were lucky. Things turned somewhat positive. Spreads starting moving in, deals were being done, refis took off,” Pollock explains.
The concept of a government stress test may be here to stay. “I think that having these stress tests in such a public way might eventually lead to a mandate,” says Peter Davis, head of the U.S. services credit risk team at Ernst & Young LLP.
For now, stress tests remain voluntary, as endorsed by Federal Deposit Insurance Corp. chairman Sheila Bair in a May 7 statement. But shareholders of regionals and other institutions may start lobbying for similarly public government audits. “You could quite possibly see pressure in that context,” according to Don Vangel, principal in Ernst & Young’s financial services office. But Davis points out that even with 150 regulators the test of the top 19 banks proved challenging. And Pollock believes that the “regulatory bodies and the banks will vigorously resist” any attempt to extend such public audits beyond those already completed.
At the same time the leaked test results were flooding the market, the FDIC’s Bair was telling the folks on Capitol Hill that the days of too-big-to-fail are numbered. “Notwithstanding expectations and industry projections for gains in financial efficiency, the academic evidence suggests that benefits from economies of scale are exhausted at levels far below the size of today's largest financial institutions,” she told the Senate Banking Committee last week. “Also, efforts designed to realize economies of scope have not lived up to their promise.”
What can be done? “A strong case can be made for creating incentives that reduce the size and complexity of financial institutions as being bigger is not necessarily better,” Bair testified. Additionally, she promoted the creation of a systemic risk regulator and proposed a “legal mechanism for the orderly resolution of these institutions similar to that which exists for FDIC insured banks. The purpose of the resolution authority should not be to prop up a failed entity indefinitely, but to permit the swift and orderly dissolution of the entity and the absorption of its assets by the private sector as quickly as possible.” Such a regime should be “an urgent priority,” she testified.