There was been a lot of drama over the last week, which we have certainly contributed to, about the stress tests. It was all very exciting, finally seeing numbers purporting to show how healthy or unhealthy each bank was. But let’s recall what the point of this whole exercise was.
Depending on your perspective, the goal is either to restore confidence in the health of the financial system, or to ensure the health of the financial system, which are obviously closely related. We care about the health of the financial system because the financial system is critical for the health of the economy as a whole: without banks that are willing to lend money for people to buy houses, cars, and consumer goods, or for businesses to invest in real estate, factories, inventory, software, etc., none of these things will happen. So the ultimate goal is to ensure the availability of credit.
There are ways to measure the availability of credit directly. One of them is the Fed’s quarterly survey on bank lending practices, which was released earlier this week (hat tip Calculated Risk, as usual). For a quick overview, I recommend the charts. The charts show you, for each quarter, the change in supply of or demand for credit in that quarter – in other words, they are you showing you the first derivative.
The quick summary is that lending practices tightened for every category of loans for the seventh straight quarter (in some categories, tightening has been going on even longer). In most categories, the rate of tightening – the difference between the number of banks who say they have tightened credit and the number who have loosened it – is lower than the peak in the October survey. But this just tells us that the second derivative is positive, which was to be expected, since the October peak was the highest ever recorded in every category, when virtually every bank was tightening credit. The first derivative is still negative, which means it is still getting harder to get a loan across all major categories.
Note that the latest survey was taken in April, which is after the banks’ spectacular first quarter results. So despite the major banks’ insistence that they are healthy and they can earn their way out of their troubles – which appears to be the government’s strategy as well – it is still getting harder to get a loan. Now, it may actually be true that the banks can earn their way out, if you look at the second figure, which shows that virtually all banks have been increasing their spreads on commercial and industrial loans every quarter for the past year. As money gets cheaper, competition dies off, and lending standards get tighter, profits go up.
At some point, increasing bank profitability – if it can be sustained – should translate into increased competition, lower spreads, and increased availability of credit. But we are a long way from that point.
The other thing the charts show is that demand for credit has been negative for several quarters in every category, with the exception of prime residential mortgages, which turned positive in the April survey – almost certainly due to refinancing at historically low rates. So even though we saw increased consumer spending in Q1, it was with lower borrowing. This reflects the expected shift in consumer behavior away from debt and toward saving.
By James Kwak
The Baseline Scenario 
The “profits” at these banks are an illusion. The banks’ earnings (including those of the former investment banks) are up largely because of the AIG off-market unwinds in 1q09. That’s more a one-off.
It’s doubtful competition’s going to result in lower rates either. These stress-tested banks need to hoard whatever free cash is being generated as an off-set to the massive exposures they still retain. They’ve already liquidated anything with a bid > 0. Now they’re left with the real waste products on their books, which just sit there bubbling and churning, eating a hole thru their balance sheets and income statements.
Besides, lending never was a money-maker for them: Relative to what these guys are used to reporting as earnings when leverage was 30: and 40:1, it’s very difficult to post huge numbers from lending alone when your primary mission is to get leverage down to the < 20x and into the low teens.
A big part of the rally in these bank stocks — stress tests aside — is coming from the earnings reports of 1q09, which is emboldening the banks to issue equity while the market’s willing to believe they’ve turned the corner. Having Geithner’s Treasury and Bernanke’s Fed step back out of the limelight while all this is being reported, only to come forth now and again like some Greek Chorus extolling the virtue of their charges and wards, is eerie. Both the banks and their government “regulators” know the story here — money’s being funneled to these banks by every means available to make it look like they’re ongoing concerns (the AIG conduit, the off-market portfolio unwinds, the subsidized lending, etc.) with a viable business model.
What happens when everyone realizes the US Government can no longer re-direct tax to the banks to make it look like they’re actually earning even a small spread above a wafer-thin cost of funds?
The focus has been primarily one of willingness of banks to lend rather than the willingness of consumers and businesses to borrow. Richard Koo makes a compelling argument that in a balance-sheet recession the primary problem is unwillingness to borrow:
http://www.csis.org/component/option,com_csis_events/task,view/id,1828/
I suspect that the tightening of credit standards by banks is more of a return to saner lending practices and simply a reversal of the easy money policies of the recent past and that credit-worthy borrowers can obtain credit. The problem is the private sector doesn’t have the appetite to take on new debt which is removing demand from the economy and worsening debt burdens from reduced income to retire the existing debt. This will create another crisis of nonperforming loans which will collapse many banks.
What a stress!
Now 19 large bank holdings companies (BHCs) have been told what to should do in order to hang around and so they should at least be a little bit less stressed… but what should we do with these stress-test results?
First it hard for us to interpret the results of the stress test because they all refer to risk-weighted assets” and this we know that no matter its pompous name this does not mean anything absolute. Not only are the weights completely arbitrary, like for instance 20% for triple-A rated assets, but also those weighing, the credit rating agencies, have clearly shown themselves not to be the most very trustworthy risk surveyors. It also makes any comparisons between BHCs impossible since the differences between the risk-weighted assets could be larger than between apples and oranges.
But second and most importantly the stress test does not include any type of recommendation. Do we want to strengthen the weaker BHCs so that these survive or are we looking to show who are weak so that we can strengthen the stronger to make sure that some of the BHC survive? Why do we not put all our money in the group outside the BHCs? What a stress!
A lot of what looks like loan growth or demand for loans, especially business loans, is really refinancing. Really robust economic growth is necessary to produce new loan demand or opportunities to lend to new businesses or lend more to exisiting growing businesses.
Will someone please respond to William Black’s point that AIG was stress-tested in 2008 and came up roses, as were Fannie and Freddy earlier in the decade. Why does anyone listen anymore? These numbers seem worth far less than the paper (electronic screen these days, I guess…) they are printed on. Which brings us back to the title of your post here: what’s the point? PR, I guess. If they can sucker in even a few more people yet one more time, that much more into their pockets.
Got a link on Black and AIG, Boris? That’s interesting.
The video clip of William Black about AIG stress testing is available on this blog post:
http://www.fundmymutualfund.com/2009/05/william-black-on-yahoo-techticker.html
along with some others of note.
Oops, just posted the link below.
Any “test” that thinks a bank with a market cap of 1 percent of total book assets only needs to raise common equity of .25 percent of total book assets is not really planning for the worst case or the baseline scenario.
You are absolutely right Linus Wilson
It is time besides talking about riskweighted assets also start talking about equity to total bank assets
I can’t help but point out that the following sentence is simply not true, except given all the baseline assumptions we need to stop making forever following this crisis:
“without banks that are willing to lend money for people to buy houses, cars, and consumer goods, or for businesses to invest in real estate, factories, inventory, software, etc., none of these things will happen.”
No. No. No. Despite the fact that this appears to be so in any country where banking is strictly a private monopoly, this never was and never will be true except in a relativistic circumstantial way.
Furthermore, only a banker could possibly believe this one:
“So the ultimate goal is to ensure the availability of credit.”
Unless of course credit were designed as a public utility or managed in a competitive way between public and private sector, as is done in Germany and perhaps Sweden, which gets the absolute highest marks in the world for democracy and quality of life.
The essential discussion is what are the steps necessary in order to ameliorate quality of life and design a sustainable productive economy. Where banking fits in that is now, and should always have been, a very open question.
Leland
I like your article. I would like to post it to my blog too. http://abhi.com.np/blog/
I like your article. I would like to post it to my blog too. Hope that is ok with you!!
http://abhi.com.np/blog/
I think everybody is stress during recession
I just want to say I enjoyed reading this particular presentation :-)
One of the reason banks have not lend more is because of uncertainty over government action that may threaten their survival (e.g. WaMu and Wachovia). From the bank’s perspective the choice between lending and survival is an obvious one.
In returning to the actual question, on appearances it would seem that the bank stress tests undertaken by the Fed and Treasury was more of a PR/Cosmetic exercise in trying to restore some ‘trust’ in to the system.
The fundamental problem afflicting banking todate is not the write downs they have been forced to make, but a lack of lending between themselves and from money markets in general, or money markets loans where the terms and insurance costs are so high as to make them unaffordable – hence quantitative easing on both sides of the pond.
The credit/liquidity crisis is actually a matter of confidence or trust. Living in Asia and dealing with both bankers and regulators here, I can assure many readers that banks in the region are flush with cash/deposits – unfortunately, as the US found to its peril, that money will not be coming your way as most are now risk averse, meaning that people want a no-risk destination for their money. Obviously, this has removed a huge swathe of money from the money markets, if all of you get my drift, this has resulted in both the liquidity crisis, which has led to deleveraging of assets, which has further exacerbated the credit/liquidity crisis. All this in most instances is a result of the development of the ‘shadow banking system’, addiction by banks to cheap inflows of short term cash and inability to replace it with depositors cash.
An examination of the tsunami which hit Northern Rock in the UK clearly demonstrates this process, one I’m afraid to say is of a huge proportion in the USA – hence, even with the supposed US$700 billion bailout and guarantees in excess of US$11 trillion, the liquidity crisis continues apace. Citi’s Matt King wrote an interesting 100 page report on this in late January, and whilst at the time he was crystal gazing, its uncanny how accurate many of his projections have become in May this year.