Big Bank Phobia: Liquidity, Stupid, Not Just Capital

This is the second of a three-part series rebutting the three most popular approaches toward lowering the systemic risk of large U.S. banks. Make sure to read Part 1, on breaking up the big banks and Part 3, on the folly of bringing back Glass-Steagall.

NEW YORK ( TheStreet) -- The Federal Reserve's annual stress test process has done a lot of good, but the tests need to be broadened to include stresses to liquidity as part of the regulator's "severely adverse scenarios."

This is the second of our three-part series rebutting the three major ideas for ending the perception that the nation's largest banks are "too big to fail," focusing on the emphasis of regulators on making sure large banks have enough capital to avoid another government bailout.

In part one we discussed the prospects of simply breaking up the six largest U.S. banks. The easiest way for politicians to achieve that goal, rather than passing legislation directly to break them up, would be to increase the capital ratio requirements for the big six banks so high, that their shareholders would conclude that breaking up would be the only choice.

In part three, we consider the cries to bring back the Glass-Steagall amendment to the Banking Act of 1933, which, for the most part, separated investment banking from commercial banking.

Dodd-Frank, Stress Tests and Capital

As 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%.

No matter how you slice it, the big six have greatly improved their capital strength over the past five years.

The group passed the most recent set of stress tests in March with flying colors. Under the Fed's severely adverse scenario, including an increase in the U.S. unemployment rate to over 12% in the second half of 2013, with a 50% drop in equity prices and a 20% decline in real estate prices, the regulator said Citigroup would emerge with a minimum projected Tier 1 common equity of 8.3% through the end of 2014. This was the highest projected minimum ratio among the big six.

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.

The Federal Reserve's 2013 stress tests included a particularly dire economic scenario, but said nothing about the type of wholesale liquidity lockups that in 2008 pushed Bear Stearns and Lehman Brothers to the brink of failure almost instantly, because of the companies' reliance on overnight funding.

The immediate cause of Washington Mutual's failure in September 2008 was also a liquidity problem, because a retail run on deposits against the bank seemed to be gaining strength. Of course, with so many poorly underwritten mortgage loans, many featuring payment options that allowed loan balances to rise while home prices were crashing, Washington Mutual could have run out of capital if it went on operating.

In a speech in on May 2, Federal Reserve Governor Daniel Tarullo said that during 2007, "liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure on asset prices, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets. The margin calls and booked losses would start another round in the adverse feedback loop."

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."

The Basel III Liquidity Coverage Ratio (LCR) is designed to ensure "that a bank has an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted into cash easily and immediately in private markets to meet its liquidity needs for a 30 calendar day liquidity stress scenario," according to the Basel Committee's statement in January.

The LCR will be introduced in January 2015, with a 60% minimum, rising by 10% a year until January 2019, when the requirement will be 100%.

The LCR is specifically designed to prevent immediate funding blowups of the type experienced by Bear Stearns and Lehman Brothers. The required coverage of liquidity needs for 30 days will allow enough time for regulators to implement an affected bank's approved orderly liquidation process, or "living will," as required by Dodd-Frank.

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."

The Bottom Line

So much of the "too big to fail" problem has been caused by the reliance of some banks on short-term funding, and the immediate drying up of that funding, from all sources, when things turn sour. The largest U.S. banks all have significant deposit bases now, including Goldman and Morgan Stanley, which converted to traditional bank holding company structures in 2008.

U.S. bank regulators can implement minimum short-term liquidity requirements in excess of those envisioned under Basel III, and they can do it well in advance of the planned implementation of the Basel III LCR.

And the Federal Reserve can incorporate liquidity stress testing into its next annual round of large-bank stress tests, beginning next March, showing Washington and the public that it is doing everything it can to prevent another industry bailout.

-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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