As a person who prides himself on communicating, a blog title such as “banks’ capital stress tests” is a little bit scary. Just because I can imagine how it must look to most people. You might be thinking, “Ugh! What the heck does that mean?”
Well banks are highly leveraged organizations. For every dollar that you deposit into a checking or savings account, they are only required to keep on hand $0.10 for every dollar of customer deposits – these are known as reserves. The rest of the monies they are free to invest in order to make money. So the leverage here is similar to that on a consumer mortgage. If the customer puts up a down-payment of 10%, and a bank finances the other 90%, then the leverage is 9 to 1. Does this make sense?
Banks are somewhat limited in what they can invest deposits in, but because there is a menu of things that they can invest in, and all with different risk profiles, some banks naturally have a higher risk profile than others. Those that have invested in riskier investments are required to keep more reserves on hand than those with less risky investments. Hence, the obscure title of the blog: “banks’ capital stress tests.”
The Federal government announced in February that 19 of the largest banks in the U.S. would undergo rigorous capital tests. These tests were designed to evaluate the riskiness of the investments banks had made with the other $0.90 of every customer deposit that they are not required to keep around in the form of a reserve. The tests were going to be more stringent than those that are typically applied. The idea was to publicly demonstrate to the investment public that the largest banks in the U.S. were more than solvent. Hopefully then the fear that was surrounding the financial sector would dissipate. That’s the idea.
So now the results of those stress tests are about to be made public. According to the preliminary information 10 of the 19 institutions need more capital on hand in order to satisfy the stress tests. In other words, in terms of our mortgage model there needs to be more equity in these banks. Originally it was believed that as many as 14 of the 19 would need additional capital and now the number is only 10. Also, a lot of the quarterly earnings numbers from banks have indicated to the investment community that things are not as bad as had been assumed.
Now you may be wondering how the banks can just magically increase their capital? And in particular you may be concerned that they are going to try and tap some of the bailout monies, yes? In general, government officials believe that these banks should be able to raise their capital from private investors who are emboldened by the glut of information about each of the banks as revealed by the stress tests. I think that is a good bet. Many well monied institutional investors have been sitting on the sidelines since February awaiting the results of the stress test. Because the results are likely to be more positive than had been anticipated I would expect an inflow of private money into these institutions.
So what are the ramifications for those banks that do have to raise additional capital? One of the consequences will be that their dirty capital laundry is going to be aired in public. That could result in a sell-off of those institutions’ shares. Also, the credit ratings agencies may downgrade the credit of those institutions and that would result in an increase in the borrowing costs for those institutions. Those increased borrowing costs will lower profitability as well. The lower profitability will hurt the institutions’ ability to generate its own capital. And…Can you see the potential for a downward spiral here? However, my intuitive sense is that is not going to happen. Nonetheless, it will be interesting to see how folks respond to the stress tests. It will be a good indication for all of us investors as to the overall confidence in the burgeoning recovery.
Jason
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