Dodd-Frank, Stress Tests and CapitalAs required under the Dodd-Frank Wall Street Reform and Consumer Protection Action of 2010, the Federal Reserve has been conducting annual stress tests to gauge the nation's largest banks' ability to withstand a severe and immediate recession, while continuing to lend and remaining "well-capitalized," with Tier 1 common equity ratios of at least 5.0%.
Here's a quick look at the capital ratio improvement for the six big banks known as "megabanks," under the misguided plan to "walk away" from the Basel III capital standards, not to mention Dodd-Frank's capital directives, that was proposed by senators Sherrod Brown (D., Ohio) and David Vitter (R., La.) last month:
- Bank of America's (BAC) ratio of tangible common equity to tangible assets increased to 6.78% as of March 31 from 3.35% at the end of 2007, according to Thomson Reuters Bank Insight. The company reported a March 31 estimated Basel III Tier 1 common equity ratio of 9.42%, putting it in compliance with the Federal Reserve's proposed enhanced capital requirements years ahead of the full implementation in January 2019. The Basel III Tier 1 common equity ratio applies risk-weighting to the assets in the denominator, unlike the tangible common equity ratio. For global systemically important banks (GSIFIs), an additional capital buffer over the 7.0% minimum Basel III Tier 1 common equity ratio is required. Bank of America's buffer is 1.5%, making for a full Basel III Tier 1 common equity ratio minimum requirement of 8.5%.
- JPMorgan Chase's (JPM) March 31 tangible common equity ratio as of March 31 was 6.28%, increasing from 4.76% at the end of 2007. The company's estimated Basel III Tier 1 common equity ratio was 8.9% as of March 31. JPMorgan's fully phased-in Basel III Tier 1 common equity ratio requirement will be 9.5%, including a GSIFI buffer of 2.5%.
- For Citigroup (C), the tangible common equity ratio was 8.71% as of March 31, increasing from 2.72% at the end of 2007. The company's estimated Basel III Tier 1 common equity ratio was 9.3% as of March 31. Citi's fully phased-in Basel III Tier 1 common equity ratio requirement will be 9.5%, including a GSIFI buffer of 2.5%.
- Wells Fargo's (WFC) tangible common equity ratio was 8.29% as of March 31, increasing from 5.99% at the end of 2007. The company's estimated Basel III Tier 1 common equity ratio was 8.39% as of March 31. Wells Fargo's fully phased-in Basel III Tier 1 common equity ratio requirement will be 8.0%, including a GSIFI buffer of 1.0%.
- For Goldman Sachs (GS), the March 31 tangible common equity ratio was 6.95%. A comparable figure for year-end 2007 is not available since the company was not required to publicly disclose its capital ratios until it was registered as a bank holding company in 2008, making it eligible for access to the Federal Reserve's discount window. But based on the reported numbers, Goldman's ratio of tangible equity capital to total assets was 3.82% at the end of 2007. The company's estimated Basel III Tier 1 common equity ratio was 9.0% as of March 31. Goldman's fully phased-in Basel III Tier 1 common equity ratio requirement will be 8.5%, including a GSIFI buffer of 1.5%.
- Morgan Stanley's (MS) tangible common equity ratio was 6.43% as of March 31. Like Goldman, the investment bank became a bank holding company during 2008, so a comparable tangible common equity ratio isn't available for the end of 2007. However, based on the reported numbers, Morgan's ratio of total shareholders' equity to total assets was just 2.99% as of Dec. 31, 2007. The company's estimated Basel III Tier 1 common ratio was 9.8% as of March 31. Morgan Stanley's fully phased-in Basel III Tier 1 common equity ratio requirement will be 8.5%, including a GSIFI buffer of 1.5%.
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.
That "feedback loop" is particularly dangerous for financial companies that lack a deposit base. Since "short-term wholesale lending against all but the very safest collateral froze up, regardless of the identity of the borrower," during 2007 and 2008, "the universe of financial firms that appeared too-big-to-fail during periods of stress extended beyond the perimeter of traditional safety and soundness regulation," Tarullo said. After describing the Liquidity Coverage Ratio that was negotiated under Basel III, but has not yet been fully implemented by the Federal Reserve, Tarullo went on to say "a more interesting approach would be to tie liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements." "This approach would reflect the fact that the market perception of a given firm's position as counterparty depends upon the combination of its funding position and capital levels. It would also supplement the Basel capital surcharge system, which does not include use of short-term wholesale funding among the factors used to calculate the systemic 'footprint' of each firm, and thus determine its relative surcharge."
In his report on May 3, Mosby called liquidity "an underappreciated survival tool" for large banks, and said that "by the end of 2008, our Large Cap Banks' coverage of a retail run on the bank had fallen below 100%." Of course, the government took very significant steps during the crisis to mitigate the risk of bank runs. The FDIC temporarily waived all limits on deposit insurance for most checking accounts, while eventually making permanent an increase in the basic deposit insurance limit to $250,000 from $100,000. According to Mosby, "the coverage ratio for a retail run on the Large Cap Banks has risen to above 150%, the highest level we have seen in the 2000s." A retail run on deposits is a banker's worst nightmare, and it has been a very rare event in the United States for quite some time, with the FDIC taking a lot of the credit. "Additionally, wholesale and institutional coverage ratios have improved from below 200% to around 400% today," according to Mosby. The most important liquidity measure for banks when trying to curtail systemic risk is "a wholesale or institutional run on the bank," Mosby wrote. "If a bank's wholesale or institutional coverage ratio falls too far and a bank's marketable assets begin to become less liquid, it could be forced to use the Fed to cover any significant loss of funding. Ensuring that the Large Cap Banks have excess liquidity is a component of getting the government out of making Large Cap Banks too Big to Fail."