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Wednesday, 16 April 2014

Fed stress tests a buy signal for the sector

The extent of the broad system-wide improvement in banks is clear, says IFR editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

WITH THE EXCEPTION of government-owned Ally Financial (which failed abysmally but said the tests were fundamentally flawed), US banks passed the Fed’s stress tests some with flying colours, others with less room for manoeuvre. That’s good news, of course. But it did strike me as rather odd that the Fed’s outcomes were not at all consistent with the results of the tests the banks conducted on themselves.

The question that arises is: who’s right? In reality, it’s impossible to know one way or the other. Some critics came out in the wake of the results and criticised the Fed for not being aggressive enough. Others moaned that the banks were still under-estimating risk. Who knows? Like any rules-based simulation, what you get out of a model is totally a function of what you put in.

Given that the Fed set out the basis of its stressed scenario very clearly – a peak unemployment rate of 12.1%, a drop in equity prices of more than 50%, a decline in housing prices of more than 20% and a sharp market shock for the largest trading firms – I would have thought the numbers would compare rather more favourably.

Bank of America Merrill Lynch reckons its Tier 1 common ratio would fall to 7.7%, way above the 6.8% Fed number. Morgan Stanley’s 6.7% was miles from the Fed’s 5.7% while JP Morgan’s gap was even wider at 7.6% against 6.3%. Goldman Sachs’s 8.6% minimum 4Q2014 Tier 1 common ratio looks weirdly out of kilter with the Fed’s projected 5.8%, while PNC’s own projection of 7.9%, by contrast, came in below the Fed’s 8.7%.

FOR THE INVESTMENT banks, the size of the trading books and assumed loss severity estimates will have skewed the results quite dramatically; it’s no accident that Goldman and Morgan Stanley pulled the lowest minimum Tier 1 common ratios under the stressed scenario.

Morgan Stanley explained in its disclosure that as a bank holding company with substantial trading and counterparty exposures, it had to apply “a hypothetical, instantaneous global market shock to its trading book, private equity positions and counterparty credit exposures as of the market close on November 14 2012. The hypothetical global market shock prescribed by the Federal Reserve was generally based on the price and rate movements observed in the second half of 2008. It also incorporated hypothetical eurozone-based shocks, including sharp increases in government yields, widening corporate and sovereign credit default swap spreads, and a large depreciation of the euro against major currencies.“

I’d say the exercise was a strategic buy signal for the US banking sector

It’s true, as some of the critics of the Fed approach to the tests have pointed out, that it’s far from clear what impact a bank collapse would have on the sector, or how banks will be able to source liquidity in a stressed environment so critics argue we should exercise caution.

Never say never but I severely doubt the several standard deviation price moves we saw on several days in the aftermath of Lehman Brothers’ collapse will be repeated. Why? For a number of reasons: the progress the banking sector has made on fattening its capital buffers; the sector’s still-evolving but certainly more conservative business profile; the upgrade in risk management practices and reporting; better transparency around counterparty exposures and concentrations; the dramatic reduction in illiquid structured product inventory throughout the system; and more cautious underwriting and credit approval standards. And of course we’re also living under a much tougher regulatory regime. All-in-all, it would tend to lead me to think the Fed probably overdid it.

THE EXTENT OF the broad system-wide improvements are clear when you bear in mind that even with projected losses at the 18 bank holding companies included in the exercise of a pretty scary US$462bn over the nine quarters of the hypothetical stress scenario (although down from US$534bn last year), the aggregate Tier 1 common capital ratio would fall to 7.7% in the fourth quarter of 2014 from 11.1% in the third quarter of 2012. (I say “only”; it’s actually a fairly dramatic fall but the point is it wouldn’t destroy the sector and capital levels would remain above regulatory minimums). Remember that the actual aggregate Tier 1 common ratio for the 18 firms at the end of 2008 was around 5.6%.

Notwithstanding the fact that equity investors may be somewhat confused as to how to read the discrepancies between the Fed and the banks, I’d say the exercise was a strategic buy signal for the US banking sector.

We may get some near-term volatility in bank stocks as dividend and buyback plans are announced, but that’ll result in some tactical rotation. But by having a 48-hour window to alter their plans to return capital to shareholders, banks will at least be able to avoid the ignominy of having their plans turned down, as happened with Citigroup in 2012 and which ended up being another nail in the coffin of Vikram Pandit’s reign as CEO.

Mike Corbat’s US$1.2bn stock buyback target through March 2014 was clearly set at a level that guarantees it’d get approval. Other banks will do the same. Net-net, I see no reason why the sector shouldn’t continue its ascent, particularly as the US economy clambers its way back to sustainable growth.


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