This special guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
Q: Are the annual stress tests good for bank stocks?
Early in 2009, when the Federal Reserve Board began the annual exercise of “stress tests” for banks, confidence in the US financial institutions was nonexistent. The year before, Treasury Secretary Hank Paulson almost single handedly cratered the US economy by embracing the creation of a “Super SIV” to buy bad assets from the largest banks. Paulson’s ill-considered comment told investors that US banks like Citigroup (C) were insolvent. At the time, JPMorgan (JPM) was trading below $30 per share and other large banks were similarly discounted.
As part of a broader effort to restore confidence in banks, the Supervisory Capital Assessment Program or SCAP was designed to measure whether the 19 largest banks with more than $100 billion in assets had sufficient capital. The key objective of the SCAP was not to actually measure capital per se, but instead to restore investor confidence in holding bank debt. In that sense, at least, the SCAP was successful. Kudos to Messrs Bernanke & Geithner.
Yet the necessary decision to report the results of the SCAP publicly had significant future implications for banks and also for investors. In 2009, investors were concerned about a growing federal role in the banking system. And that is precisely what has occurred. The SCAP evolved into the Comprehensive Capital Analysis and Review (CCAR), which is the key part of the stress test duet that determines if banks can increase cash returns to investors. The Fed noted in May 2009:
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“The unprecedented nature of the SCAP, together with the extraordinary economic and financial conditions that precipitated it, has led supervisors to take the unusual step of publicly reporting the findings of this supervisory exercise. The decision to depart from the standard practice of keeping examination information confidential stemmed from the belief that greater clarity around the SCAP process and findings will make the exercise more effective at reducing uncertainty and restoring confidence in our financial institutions.” |
When the Dodd-Frank law was passed a year later in 2010, Congress included an expanded legal mandate to conduct annual stress tests and for hundreds of banks. In October 2012, the various federal regulatory agencies issued final rules implementing stress testing requirements for hundreds of public and private companies with over $10 billion in total assets. Most of these smaller institutions outside of the original 19 banks had no part in the 2008 financial crisis and were in fact victims. The bank stress tests continue the fine American tradition of punishing the victims.
Since 2012, the stress tests have devolved, from a modestly useful annual process focused on the top institutions to a monumental waste of time and money. This effort is focused on most of the US banking industry as measured by assets. The chief architect of this regulatory effort was former Fed Governor Daniel Tarullo, who was responsible for bank supervision and resigned earlier this year.
Governor Tarullo turned the stress test process into a nearly continuous form of supervisory torment involving bank management, directors and legions of consultants and lawyers. JPM CEO Jamie Dimon remarked frequently about the cost of stress tests, living wills and the various other requirements of Dodd-Frank. On top of required levels of capital, the Fed under Tarullo’s leadership proposed capital buffers and capital surcharges partly based upon the subjective stress test performance of each bank.
The stated point of this exercise is supposedly ensuring the safety and soundness of US banks, but the reality is far different because the process has shifted from a short-term focus on restoring confidence in bank debt to an annual media event that impacts bank equity. So intense is Wall Street's interest in how stress tests could affect bank earnings that even Fed Chair Janet Yellen has become involved in the media frenzy.
And the stress tests contain no information that would be material to investors. Violating the traditional confidence of the supervisory process to release stress test results serves no useful purpose, especially given that the tests are different for each bank. There is no comparability one bank to the next. How are analysts much less investors supposed to use this chopped salad?
First and foremost, the bank stress tests do not measure the ability of a bank to weather the types of market stress seen in 2008. As regulators have known for decades, income is the key determinant of a bank’s ability to offset credit losses. Income, net of provisions for future losses, is also a key factor when it comes to predicting a bank’s probability of failure and thus maintaining investor confidence.
When a bank starts to show (or event hint at) red ink due to climbing credit costs, investors start to flee and liquidity evaporates. The amount of capital the bank may or may not possess is immaterial, as illustrated by the events of 2007 and 2008. The added uncertainty caused by off-balance sheet finance (using the very same SIVs made famous by Secretary Paulson) led to the failure of many large firms from 2008 onward.
Yet the only time that a bank actually consumes capital is when the institution fails and its net assets are being sold. As shown by the situation facing Citi in 2008, the GSEs, and in Italy last week, by the time that we actually start talking about a bank’s capital, that institution is already dead.
Second, because of the public nature of the stress tests, the Fed and other regulators have become the very public arbiters of bank dividends and stock repurchases. The annual process of conducting the Dodd Frank Act Stress Test (DFAST) and CCAR has become a dual yardstick for whether a given banking organization can increase dividends and/or share repurchases to meet Wall Street’s expectations.
The fact of the Fed conducting the stress test initial process publicly in 2009 made this evolution to the public stress test process inevitable. But any benefit in terms of bank safety and soundness has been lost as the stress test exercise mutated into a media circus that each year precedes second quarter earnings by a week or so. From an equity market perspective, the Fed’s timing could not possibly be worse. Ryan Tracy at The Wall Street Journalnotes:
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“The tests will continue to matter to investors. The Fed will still use them to audit banks’ plans to boost dividends and buybacks for shareholders, and the numerical part of the exams will still be crucial to determining those payouts.” |
So are stress tests good for bank stocks? No.
The stress test process is part of the expanded regulation of the US economy by the Fed since the 2008 financial crisis. Dodd Frank has reduced the opportunities for banks to earn profits, while limiting their ability to provide new credit to support economic activity. Payouts to investors are now held hostage to the opaque annual stress test process conducted by the Fed and other regulators.
American banks have been neutered as sources of alpha for investors. Through the prohibition of principal trading activities and any type of risk lending, banks have become low risk, no alpha platforms. The stress test process has transformed the capital finance dimension of banks into a regime similar to the rate setting process applicable to heavily regulated electric utilities. This is not a problem of bank management, but of our public officials in Washington.
While the evidence continues to mount that over-regulation of banks is constraining economic growth and job creation, there are still voices in Washington that seek additional regulatory constraints on banking. Elizabeth Warren (D-MA) told The Wall Street Journal last week that President Donald Trump does not have a mandate to lessen regulation of banks. She said:
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“You do polls across this country, and I’m talking about polls of everybody—Democrats, Republicans, Independents, Libertarians, vegetarians, everybody. Somewhere in the neighborhood of 80% and upward believe that the largest financial institutions in this country need more regulation, not less regulation.” |
Senator Warren’s comment is right but only mimics what Teddy Roosevelt proved a century ago, that most people hate big banks. But is her prescription for more regulation a good idea in terms of public policy? Absolutely not. Warren’s comment suggests that politics, not substance, is her true motivation when it comes to yowling about bank regulation. But at least she is asking questions.
Looking at the patchwork of regulations, punitive capital rules and meaningless stress tests that have been embraced by Congress since 2008, there is little that either protects the taxpayer or promotes a healthy banking system.
The only thing that the current regime for U.S. banks ensures is that financials will have little upside in terms of equity valuations unless and until the regulatory situation changes. That was the whole point of the rally in banks stocks following the November 2016 election.
At about 1x book value, today most bank stocks are fairly valued given the current regulatory regime and their business opportunities. Some of the better performers among larger cap names such as US Bancorp (USB), Bank of the Ozarks (OZRK) and Wells Fargo (WFC) command higher valuations due to strong financial performance, but most banks simply do not deserve higher book value or earnings multiples in the current regulatory regime.
The financial crisis is over. The DFAST/CCAR process needs to be ended as a public exercise. Future capital adequacy analysis by regulators should be performed privately as it was prior to 2009. The regulatory burden on banks needs to be reviewed with an eye to removing regulations that fail either to make banks safer or support economic growth.
And remember that bad banks never die from lack of capital, they just run out of cash.
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the new book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.
