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Big Bank Phobia: Liquidity, Stupid, Not Just Capital

According to the Fed, Bank of America would pass through the economic nightmare with a minimum Tier 1 common equity ratio of 6.8%, followed by ratios of 7.0% for Wells Fargo, 6.3% for JPMorgan Chase, 5.8% for Goldman Sachs and 5.7% for Morgan Stanley.

The Federal Reserve a week later included the banks' plans to deploy capital through dividend increases and share buybacks to the same stress test scenario, and gave its blessing to the capital deployment plans submitted by 16 of the 18 large stress-tested banks. BB&T (BBT) of Winston-Salem, N.C., had its capital plan rejected based on a "qualitative assessment," while Ally Financial saw its capital plan rejected "both on quantitative and qualitative grounds."

The Fed approved the capital deployment plans of the big six banks, although it also required revised capital plans from JPMorgan Chase and Goldman Sachs by the end of the third quarter. JPMorgan was approved for $6 billion in common share buybacks through the first quarter of 2014 and also gained approval to raise its quarterly dividend on common shares to 38 cents a share from 30 cents.

What About Liquidity?

Guggenheim securities analyst Marty Mosby says "the stress tests don't sufficiently address liquidity risk, and they are not intended to. They only say if the banks will have enough capital."

In a report on May 13 that included seven main ideas that the big banks could present as alternatives to breaking them up, while ending the "too big to fail" perception, Mosby wrote that "a lack of liquidity is what created the last financial crisis, and no amount of capital can substitute for a lack of liquidity."

Mosby suggested that the Federal Reserve require large banks to "maintain an additional Liquidity Coverage Ratio focused on short-term liquidity."

"In addition to looking at a full retail run on a bank, Large Cap Banks should maintain 125% coverage of short-term borrowed funds with liquid assets that could always be sold within 30 days." That's stronger short-term liquidity coverage than what will be required under Basel III when its liquidity requirement is fully phased in, as discussed below.

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