Academic

The Stress Test Threats

By Gordon Smith, Christine, Hurt, Vic Fleischer, Fred Tung, Lisa Fairfax, David Zaring

The results of the bank stress tests are being leaked today (poor BofA!), but will be announced formally tomorrow, when I will be en route to leafy New Haven for this.  The joint statement just issued by the bank supervisors, setting the groundwork for said announcement, though, tells you where we're headed.  The tone is tough on banks, and I expect that the project will go over well; I'm impressed, though I'm just a lawyer.  (For the "is this whole project legal?" question, I point you to another lawyer, John Carney, who has doubts - I think he is onto something, though I suspect that working through the bank supervisors, as is happening here, helps the legality of everything more than would Treasury acting alone, as said supervisors must be "consulted" on TARP repayment, have wide authority to ensure "safety and soundness," which may be interpreted to include the most recent novel powers.)  Four observations:

• The supervisors returned to the dumb old Basel I way of measuring capital adequacy - "x% of risk-weighted assets" - rather than trusting the international models of banks (which was Basel II).  Moreover, the way they did so will require most of the 19 large banks, I expect, to raise capital.  This shrinks and delevers banks, as some critics have been calling for (though it doesn't do so as much as they might like).  Here's the stress test capital buffer: "The SCAP capital buffer for each BHC is sized to achieve a Tier 1 [ed note: this means less risky or cash-like capital] risk-based ratio of at least 6% and a Tier 1 Common risk-based ratio of at least 4% at the end of 2010, under a more adverse macroeconomic scenario than is currently anticipated."
• There is language that clears the way to get rid of beleaguered CEOs Ken Lewis and Vikram Pandit, though I still think the government might think that it owes Lewis for buying Merrill for top dollar: "firms will need to review their existing management and Board in order to assure that the leadership of the firm has sufficient expertise and ability to manage the risks presented by the current economic environment." 
• Moreover, there's a stop-your-backtalk instruction: "Supervisors expect that the board of directors and the senior management of each BHC will give the design and implementation of the capital plan their full and immediate attention and strong support. Capital plans will be submitted and approved by supervisors by June 8th, 2009."
• On the other hand, there's more of a handout.  To meet their new requirements, banks can obtain (or exchange their current TARP funds) preferred stock from Treasury that they can convert to common whenever they fall below that 4% common stock risk-based ratio: "Mandatory Convertible Preferred (MCP) in an amount up to 2% of risk-weighted assets (or higher upon request). MCP can serve as a source of contingent common capital for the firm, convertible into common equity when and if needed to meet supervisory expectations regarding the amount and composition of capital."  There is only 125ish billion left in the TARP, so the banks had better not all come for convertible preferred.
• There's a bright line rule for even asking to get out of TARP, and it's obtaining enough capital to the with the worst case scenario above: "The 19 [banks] that were subject to the [stress test] process must have a post-repayment capital base at least consistent with the SCAP buffer, and must be able to demonstrate its financial strength by issuing senior unsecured debt for a term greater than five years not backed by FDIC guarantees, in amounts sufficient to demonstrate a capacity to meet funding needs independent of government guarantees."

Full post as published by Conglomerate on May 06, 2009 (boomark / email).