Stress Tests: What About the Other 7,000?
So far, so good. Fifteen of the 19 largest financial institutions passed the latest round of Federal Reserve stress tests, opening the door for increased dividends and stock buybacks. It is indeed reassuring that these banks have built fortress-like balance sheets that can withstand potentially severe stress, including the dark-but-possible scenario of 13% unemployment, negative Gross Domestic Product (GDP) growth of 8% and dramatic drops in stock prices.
But what about the nation’s 7,338 other banks, including the 88 with assets greater than $10 billion, which haven’t been required to perform or submit these stress tests? While concerns about the institutions that are too big to fail often dominate headlines, remember that two decades ago, the combined failures of many small institutions resulted in the savings and loan crisis.
Financial stress still weighs on smaller banks. In 2011, more than one in six U.S. banks was unprofitable. Among banks with assets above $10 billion, one in 20 lost money. Historically, banks generate non-risk adjusted return on equity near 12%; last year, this measure stood at an anemic 7.86%. Looking ahead, banks of all sizes will continue to face pressure due to slow economic recovery and a heavy regulatory burden. In an environment with artificially low interest rates, banks’ net interest margins will likely remain challenged.
We should not rest comfortably, then, until all banks – not just the giants – have a better understanding of the stresses they could potentially encounter. Thousands of banks can avoid Fed stress tests but they should also:
- Understand that risk-based capital, economic capital and risk-adjusted return on capital (RAROC) are the only meaningful measures which estimate safety and soundness;
- Acknowledge that stress-tested capital for all risks within the full probability spectrum is the only true determinant of capital adequacy;
- Actively forecast capital and capital tactics under both normal and stressed scenarios as well as a scenario of business collapse;
- Use forecasted and stress-tested economic capital to annually right-size their book capital;
- Demonstrate the discipline to maintain stress-tested economic capital equal to or less than book capital at all times and in all possible conditions;
- Create and adhere to a board-approved comprehensive capital plan that covers at least three years into the future. This plan must address such issues as leverage from high loan-to-deposit ratios and growth of share of market and wallet, payment of dividends, stock repurchases and merger growth. Both before and after such capital optimization tactics the bank must demonstrate stress-tested capital adequacy.
As the economic recovery in the U.S. gains traction, it is important to remember that stress tests are not designed for the optimists among us. The economic capital of a financial institution must cover losses that are derived from events which are less than probable, but more than impossible. That would reasonably include 13% unemployment and 8% negative GDP growth. After all, there are still citizens among us who lived through such a situation during the Great Depression of the 1930s. Negative GDP growth has exceeded 8% twice since 1947. And, all but the youngest of children came perilously close to this scenario as recently as 2008 and 2009.
Surely, the economic capital of a financial institution should be robust enough to sustain events that can occur once or twice in the life of an individual. Proper risk-based capitalization is not just imperative for large banks that pose systemic risk, but also for smaller financial institutions that must also help safeguard the financial security of our communities.