Tag Archives: stress tests

Stress Tests, Lending, and Capital Requirements

By James Kwak

Despite the much-publicized black eye to Citigroup’s management, the bottom line of the Federal Reserve’s stress tests is that every other large U.S. bank will be allowed to pay out more cash to its shareholders, either as increased dividends or stock buybacks. And pay out more cash they will: at least $22 billion in increased dividends (that includes all the banks subject to stress tests), plus increased buyback plans.

Those cash payouts come straight out of the banks’ capital, since they reduce assets without reducing liabilities. Alternatively, the banks could have chosen to keep the cash and increase their balance sheets—that is, by lending more to companies and households. The fact that they choose to distribute the cash to shareholders indicates that they cannot find additional, profitable lending opportunities.

This puts the lie to the banks’ mantra that capital requirements will constrain lending and therefore reduce growth (made most famously in the Institute of International Finance’s amateurish report claiming that increased regulation would make the world’s advanced economies 3 percent smaller). Capital isn’t the constraint on bank lending: it’s their willingness to lend.

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Skew

By James Kwak

There is a common phenomenon in legal disputes over the value of something, be it a company, a piece of land, or a person’s expected lifetime earnings. Each side hires an “expert” who produces an estimate based on some kind of model. And miraculously, every single time, the expert for the party that wants a higher number comes up with a high number, while the expert for the party that wants a lower number comes up with a low number. No one is surprised by this.

Yesterday, the Federal Reserve posted the results of the latest periodic bank stress tests mandated by the Dodd-Frank Act. For these tests, the Fed comes up with various scenarios of how things could go badly in the economy, and the goal is to see how banks’ income statements and balance sheets would respond. The key metrics are the banks’ capital ratios; the goal is to identify if, in bad states of the world, the banks would still remain solvent. If not, the banks won’t be allowed to do things that reduce their capital ratios today, like paying dividends or buying back stock.

For the most part, the results look pretty good: capital levels even under the severely adverse scenario should remain above the levels reached during the 2008–2009 crisis. (Of course, there are several huge caveats here. You have to believe: first, that the scenarios are sufficiently pessimistic; second, that the banks’ current financials are accurately represented; third, that the model is sensible; and fourth, that the capital levels set by current law are high enough.)

But there’s something else going on here. As part of the stress testing routine, each bank is supposed to do its own simulation of how it would respond to the scenarios specified by the Fed, using its own internal model. And—surprise, surprise!—the banks virtually uniformly predict that they will do better than the Fed.

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New Research in Financial Regulation

By James Kwak

Not surprisingly, there is a great deal of interesting research being done in the area of financial institutions, systemic risk, and regulatory reform. Last week I had the pleasure of attending a workshop for junior law professors held by the Insurance Law Center of the UConn Law School, where I am a professor. The workshop featured a long list of provocative and weighty papers at various stages of completion. Here I just want to point out a few that are fully drafted and available on SSRN.

Robert Weber presented what should be the canonical paper on stress testing as applied to financial institutions, which has been going on for a while but became front-page news in 2009, during the financial crisis. He traces the history of stress testing back to its engineering roots in Renaissance Italy with, perhaps unsurprisingly, Leonardo da Vinci. Weber is critical of box-checking stress testing, but argues that stress testing  can be useful as a way of encouraging or inducing bank executives and risk managers to more closely investigate their assumptions and beliefs and ultimately create a “morality of quantitative skepticism.”

Gallons of ink have been spilled over the Orderly Resolution Authority established in Title II of the Dodd-Frank Act, generally over whether and how it would be used in a crisis. In 13 Bankers, Simon and I expressed skepticism that it would be used, for practical and political reasons. Joshua Mitts’s paper takes the novel approach of looking at how OLA affects managerial incentives in the pre-crisis period, arguing that it encourages bank executives to design their firms in such a way as to maximize the chance of a taxpayer bailout. This would lead them to increase their exposure to other large financial institutions and to increase the correlation of their asset portfolios with those of other large firms.

Mehrsa Baradaran takes a historical view in her paper, which is about the social contract between banks and society as expressed through banking regulation. She begins with the Hamilton-Jefferson debates over banks (which is also where we began 13 Bankers) and covers the history of banking regulation (or non-regulation) up to the 1930s, which represented the most thorough codification of the social contract: the government needs banks, but banks also need the government. The past few decades, however, have seen an erosion of this social contract, giving banks the benefits of government sponsorship and support without the obligations necessary to ensure that they serve societal ends. Baradaran argues that banking regulation should incorporate a robust public benefit test to ensure that banks are in fact helping households, the economy, and society at large.

There are other interesting papers that are sure to come out of this workshop. One small side benefit of the financial crisis has certainly been the increased attention to the financial sector and the risks it presents to the rest of us.

Remember Those Stress Tests?

I’m curious to know how banks’ 2009 final results compare to the projections in the stress tests. My suspicion is that JPMorgan and Goldman did better than projected, but Citi may have done worse. Ideally you would compare both the new loan losses recognized over the year and the profits from current operations. But there are a couple of problems with doing this. One is that the stress test results were for 2009-2010 combined, without the separate years split out. The other problem is that it’s not immediately obvious how to map the line items from the stress test results to the line items on a bank’s income statement (or to changes on its balance sheet). I might be able to figure it out with a lot of study, but I might not.

Does anyone know of someone who has already done an analysis along these lines? Or does anyone know how to do the mapping correctly?

By James Kwak

Still Skeptical About Banks

It’s getting somewhat lonelier being a large financial institution skeptic, although there still a lot of us left. I would say that among the skeptics, the general view is that we may have seen an end to bank panics for this cycle – I’m not sure anyone is saying there will definitely be another crisis in the near future – but we may not have, and we may come to regret not taking stronger measures now. (How’s that for prognostication?)

Lucian Bebchuk, in Project Syndicate (a well-intentioned collaboration that manages to sound ominous and conspiratorial), makes the argument in clear terms. First, the recent stress tests only projected losses through 2010, ignoring the large number of loans and mortgage- and asset-backed securities that mature in later years. More fundamentally, though: “Rather than estimate the economic value of banks’ assets – what the assets would fetch in a well-functioning market – and the extent to which they exceed liabilities, the stress tests merely sought to verify that the banks’ accounting losses over the next two years will not exhaust their capital as recorded in their books.” Put another way, the focus has been on the accounting value of assets, not their economic value; so for a given asset, as long as it doesn’t have to be written down before the end of 2010, there is no problem.

Bebchuk also points out that the ability of banks to raise equity capital should not be taken as an “all clear” sign. As he and others have previously argued, equity in large banks by its very nature represents a leveraged bet whose downside risk is limited by the implicit government guarantee. That is, as a shareholder, if the economy does OK and bank assets appreciate in value, you get all of the upside (leveraged by the bank’s liabilities); if the economy does terribly and bank assets fall in value, your losses are not only limited to the amount of your investment, they are further limited by the implicit guarantee that the government will not wipe you out. That guarantee is weaker than the implicit guarantee on bank liabilities, but it is still there; given the way the government has treated Citigroup, Bank of America, and GMAC, betting on the “no more Lehmans” policy seems like a sensible bet.

Most attention is now focused on the battle over financial regulation (if it isn’t on health care and energy), which is appropriate. But it may be premature to declare victory over the financial crisis.

By James Kwak

Stress Tests: The Questions Continue

From Felix Salmon:

Why did Treasury switch from TCE to the even-more-obscure common capital metric? Quite possibly to help Bank of America and Citigroup get the amount of capital they needed to raise down to a number within the realms of possibility. After all, these tests were designed so that they couldn’t be flunked. And that might have seemed a real possibility back when Treasury was still using TCE.

By James Kwak

Grading on a Curve

Mark Thoma has a great analogy for the stress tests. He picks up on this statement by Tim Geithner:

Some might argue that this testing was overly punitive, while others might claim it could understate the potential need for additional capital. The test designed by the Federal Reserve and the supervisors sought to strike the right balance.

Then this is Thoma:

I’ve given a lot of tests over the years, and I can pretty much make the mean on a test come out how I want through the design of the questions and how I score the answers. If I want a mean of 70, or around there, I can get it, and if a mean of 50 is the target, that’s possible too. . . .

If we choose a score of “70″ as the dividing point between being solvent and being insolvent, then the percentage of banks passing the test is a function of the difficulty of the stress test: how the items on the balance sheets – the answers to the questions – are interpreted.

The whole thing is a fun read. I don’t think it’s a crucial point, but I like this part of the analogy:

Why did the government negotiate the outcome with banks and how lenient were they in those negotiations? There are always students who want to argue about the result of a test, to have sections regraded, and how you respond to attempts to “negotiate” a grade can affect the percentage passing the class, particularly when – as with the stress tests – there aren’t a lot of students/banks taking the test.

By James Kwak

Help

Has anyone figured out how to make the numbers in Table 3 (PDF p. 10) in the stress test results add up? I understand what all the lines mean individually, but the presentation seems incomplete. Looking at Citi for example, I know that they expect 104.7 in losses on existing assets, but they expect Citi to make 49.0, for a net loss of 55.7. Common capital on 12/31/08 was 22.9, and 22.9 – 55.7 = -32.8, so absent recapitalization that would leave Citi at -32.8 on 12/31/10. The “SCAP buffer” (which seems like the opposite of a buffer, but whatever) is 92.6, so with the buffer Citi would have 59.8 on 12/31/10. But 59.8 is well over 4% of Citi’s risk-weighted assets of 996.2.

Maybe the model has Citi’s assets climbing up to $1.5 trillion? Or maybe the losses and “resources to absorb losses” do not have a dollar-for-dollar effect on common capital?

Anyway, it seems like at least one number is missing. If you can explain this, or link to someone who can, I will . . . be grateful.

Update: The most common theory is that 59.8 is 6% of 996.2. But I don’t think that is the explanation, for the reasons I cite in this comment reply and that Nemo also flagged. Also, Erich Riesenberg points out that the fact that this works out to 6% for Citi is a pure coincidence, if you look at the same calculation for other banks.

By James Kwak

GMAC Arithmetic

Calculated Risk has a table listing all of the leaked stress test figures so far. As a percentage of assets, the big banks need between 0% and 1.4% in additional capital. But there is one outlier: GMAC, with $189 billion in assets, needs $11.5 billion in capital.

This implies that GMAC is not just low on capital, it has negative capital. If you were to give GMAC $11.5 billion in new cash, it would have $200 billion in assets. The minimum tangible common equity requirement being used for the stress tests is probably in the 3-4% range. If it’s 4%, then the post-recapitalization GMAC would have $8 billion in tangible common equity – which means that right now it has negative $3.5 billion in tangible common equity. (The situation is slightly worse if you assume that it will be recapitalized through a preferred-to-common conversion, or if the threshold is 3%.)

The thing that confuses me is that, on paper, you can’t recapitalize a company with a negative net worth. No investor would pay $11.5 billion to own 100% of the common shares in a company that is worth $8 billion. (You can recapitalize a company that is under-capitalized: if it has $5 billion in capital and needs another $5 billion, then the new investors get 50% of the company.) This is why it is important (from the government perspective) for the stress tests to show that some banks are low on capital, but not that they have negative capital.

Maybe there’s some clever accounting mechanism or financial wizardry I’m missing.

Update: OK, now that I read the stress test document (I must be the last economics blogger to do so), I see there’s a mistake above. According to the stress test, GMAC is sufficiently capitalized now; the problem is that under the “more adverse” (realistic) scenario, its 2009-10 losses will be greater than its capital. So its expected capital at the end of 2010, absent recapitalization in the interim, would be negative.

It is not arithmetically impossible to recapitalize such a company, because we don’t know that this outcome will occur with certainty. I might pay $11.5 billion to own a company that, in the more adverse scenario, will be worth less than $11.5 billion at the end of two years – if I think that the possibility of a better outcome makes the bet worthwhile. Put another way, even if its end-2010 expected value is negative, its current value is still at least a little positive, because of option value. Still, though, it’s a pretty dodgy investment, so GMAC will probably have a difficult time raising new capital by selling common stock to the private sector.

The comment Nemo made below about the difference between market value and book value is true, but I also think my response is true: if anything, market values are below book values these days.

Finally, Felix Salmon also noticed that GMAC is the outlier on the bad end.

By James Kwak

Stress Tests and The Nationalization We Got

The post was co-authored by Simon Johnson and James Kwak.

When the stress tests were first announced on February 10, bank stocks went into a slide (the S&P 500 Financial Sector Index fell from 133.13 on February 9 to 96.18 two weeks later), in part on fears that the stress tests would be a prelude to “nationalization” of the banks. This week, it has emerged that several large banks will require tens of billions of dollars of new capital, most notably Bank of America. They could obtain that capital by exchanging common shares for the preferred shares that Treasury now holds, an accounting trick that boosts tangible common equity without providing the banks any new cash. Such a conversion would greatly increase the government’s stake in certain banks, perhaps even above the 50% level, yet the markets seem relatively unconcerned this week, with the S&P 500 Financial Sector Index at 168.14 and rising.

What happened?

Back in February, America was mired in a public debate over the word “nationalization” and what it meant for our banking system, with contributions by Nobel Laureates Paul Krugman and Joseph Stiglitz, former and current Fed officials Alan Greenspan, Alan Blinder, and Thomas Hoenig, and administration figures Timothy Geithner, Larry Summers, and even Barack (“Sweden had like five banks“) Obama, among others. On a substantive level, the debate was over whether large and arguably insolvent banks should be allowed to fail and go into government conservatorship, as happens routinely with small insolvent banks. Opponents of this view who wanted to keep the banks afloat in their current form, including the current administration, beat off this challenge by calling it nationalization (more precisely, by demonizing government control of banks). Perversely, however, what we got instead was increasing co-dependency between the government and the large banks, as well as increasing influence of the government over the banks, and vice-versa. And according to the market, the banks should be quite happy with this outcome.

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Is Everyone Confused Yet? (Bank Stress Tests)

The public relations campaign packaging the bank stress tests is kicking into high gear and our professional information managers are really hitting their stride.  They face, of course, a classic spin problem: you need to get the information out there, but you don’t want to be too definitive on the first day or soon after – if you’re easy on the banks, that looks bad; if you’re tough on the banks, that might be dangerous.

The best way to handle this is by jamming your own signal – which they are starting to do in brilliant fashion.  To the WSJ you leak that BoA needs to raise a great deal of capital ($35bn); they run this story on the front page, next to a great frown on the face of Ken Lewis.  But you tell the FT that Citi will need “to raise less than $10bn” (note that the on-line FT version of this story, as of 8:30am Eastern, seems to have been adjusted downwards relative to the print edition that arrived at my house 4 hours ago.)  The NYT yesterday sounded quite upbeat.

Of course, deliberately or inadvertently confusing people is made much easier by the fact that the experts are in sharp disagreement.  Goldman’s Jan Hatzius says that the worst is now behind us in terms of loss recognition and pre-provision earnings will be much higher in the US than they were in Japan during the 1990s – here he and others are taking on the IMF’s Global Financial Stability Report.  And he has two good points in this regard, Continue reading

All About Optics (Predicting Stress Test Outcomes)

The bank stress tests are beginning to create a perception problem, but not – as you might think – for banks.  Rather the issue is top level Administration officials’ own optics (spin jargon for how we think about our rulers).

At one level, the government’s approach to banks – delay doing anything until the economy stabilizes – is working out nicely.  This is the counterpart of the macroeconomic Summers Strategy and in principle it is brilliant. “Don’t just do something, stand there,” is great advice in any crisis – eventually everything bottoms out and you can take the credit, justified or not (unless an election catches up with you first; check with Herbert Hoover.)

But American bankers apparently just cannot cooperate by lying low, keeping their mouths shut, and refraining from anything that looks like picking other people’s pockets. Continue reading