The Real Reason to Be Stressed Over Banks

NEW YORK (TheStreet) -- Think next week's release of the Federal Reserve's "stress test" will clear up any questions about the strength of bank balance sheets? Think again.

The problem with the tests is that no one seems to agree on what they mean.

If, as expected, the results are good, bulls will trumpet them as proof that, as they have been saying for months, banks are scandalously undervalued. Bears, on the other hand, will say the game is rigged, and the test is easily manipulated by banks and their regulator. If the results prove worse than expected, bulls will say--as they have already been saying--that the test was unrealistically harsh, while bears will say things are even worse than the test makes them look.

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For those few members of the public unfamiliar with the Fed's Comprehensive Capital Assessment and Review, it is an annual assessment by the top bank regulator of the ability of 19 largest U.S. banks to withstand massive shocks to the economy.

The test, mandated by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, is supposed to show what would happen to Bank of America (BAC), Citigroup (C), Goldman Sachs (GS) and 16 other financial giants if, among other things, GDP fell by 8%, unemployment peaked at 13%, home prices fell by 20% and equities dropped by some 52% below where they were in the third quarter of 2011.

To pass the test, these institutions will need to show that their so-called Tier 1 common ratio would remain above 5% under the above scenarios.

To get a bank's Tier 1 common ratio, regulators combine common stock and retained earnings, then divide by its risk-weighted assets. The measure has drawbacks, according to Boston College Finance Professor Ed Kane, because both risk-weighted assets and retained earnings can easily be manipulated.

Kane argues retained earnings are the weakest of the three components of the Tier 1 common ratio.

"They make very risky loans which accumulate high yields as if they've been earned, and then later these things aren't paid back," Kane says. "Retained earnings isn't as good as net worth, but even net worth can be cooked because you play games with assets to not write them down when they should be written down."

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