Banking Law

FinCriAdvisor claims that's what's good for the Big 19 will be great for the rest of the pack, or at least that's what they claim the federal banking regulators think.

Banks nationwide should brace for a perfect storm of harsher exams, deposit flight, dry capital markets and share price declines due in large part to the results of the stress tests of 19 core banks.

Because the core banks - those with assets of $100 billion or more - fared reasonably well (see test results), they are expected to attract renewed interest from investors and customers away from regional and community banks, explains Joe Harenza, CEO of Griffin Financial Group in Reading, Pa.

At the same time, the methodology of the stress tests, such as examiner scrutiny of tangible common equity (TCE) and highly customized, portfolio specific analysis of an institution's ability to withstand economic stress, is likely to be expanded to all institutions, adds former OCC Chief Counsel Brian Smith, now a partner with Latham & Watkins in Washington, D.C.

Smith claims that community banks are already seeing this in the case of the commercial real estate "guidelines," which, Smith claims, are being enforced by field examiners as if they were fixed rules. Obviously, any one attorney in private practice gets to see only a slice of the entire banking community; however, my slice and Brian Smith's slice of the business look remarkably similar. The heat is on commercial real estate.

Smith and consultant Joe Harenza posit that the methodology developed by the regulators in connection with the recent stress tests of the largest 19 commercial banks will be applied, with less flexibility and custom-cutting, to smaller banks. Other experts quoted by FinCriAdvisors think that as these stress tests take place, it will have the effect of driving bank investors away from community banks and back to the bigger banks, which is the opposite of the case has been recently. Here's why:

The customized loss estimates on various asset classes came from a negotiated consensus between the banks and stress test examiners, Harenza says. The same thing happened regarding pre-provision reserves. "The moral of the story is that it was tailor made to each of the 19 institutions," he says. "The banks contested and arm wrestled the government." As a result, Citigroup went from needing an additional $35 billion in common equity to just $5.5 billion, he says, citing a Wall Street Journal report.

But regional and community banks will not be able to offer input to examiners and will not receive tailored loss estimates, Harenza says. Yet several analytics firms - Barclays Capital, SNL Financial, Sterne Agee Research - already have released "bank of the envelope" estimates of TCE shortfalls by non-core banks. "Now what you have are buy and sell recommendations on small- and mid-cap organizations made on flawed analyses. That's a killer," Harenza says. "This may not only impact valuation and ability to raise capital, but competitive position as well."

Great news for community bank stocks, eh?

One other reason that community bank stocks may suffer vis-a-vis the big banks is that the big 19 received "the federal government's imprimatur," which gives those banks an advantage.

Since the financial crisis emerged, many depositors and investors have abandoned core banks in favor of community banks in a flight to safety and easier loan terms, Harenza says. "Now, when the government stands up and says half these guys are healthy and it won't let any of them fail, it has to hurt community banks." In addition, by making the test results, earnings projections and capital plans of core banks transparent to the investment community, it leaves a "big question mark" about the relative safety of community banks that are not subject to such transparency and hurts their ability to raise capital.

One commentator opines that this situation won't hurt the "good" community banks much, and I think that I agree as to those publicly traded banks. If you're a community bank that is held privately, however, this could hurt private capital raising efforts (outside of TARP, with all of its baggage).

When I first started to read this article, I thought that they might be making a mountain out of a molehill (not that there's anything wrong with that in the blogosphere) because stress testing is something I've seen clients go through voluntarily in the past and it is not a new concept. However, Smith alleges that this time the testing will be different.

Smith says stress testing is not new, but the emphasis represents a real "shift" to a more "holistic" approach to bank examinations and "decided emphasis" on TCE , in large part because investors demand it. "The stress test was in many ways field testing how these things work" for all institutions, he says, noting that such tests previously focused on discrete areas of an institution, not the entire company. He also suspects regulators had been jointly developing the approach before the crisis erupted, perhaps in reaction to Basel II. "We genuinely believe this signals more of an aggressive, holistic, comprehensive approach to bank supervision."

In addition, the focus on TCE is here to stay, Smith says. "It's like a big balloon - you blow it up and start to press it in from one side, the stress keeps pressing, pressing, pressing. Is there a way to prevent it from bursting?" if products sour, economic pressures build and capital becomes scarce, he asks. "What the Fed is saying is that in order to manage this properly you have to stress test them all" and use TCE as a buffer.

[...]



...[T]he stress test methodology is a strong indicator that all regulators are moving toward highly customized, portfolio specific analysis resulting in individualized capital requirements that includes analyses of past loan performance, portfolio composition, origination vintage, underwriting standards, borrower characteristics, geographic distribution, international operations and business mix.

One more thing to keep community bankers tossing and turning all night long. On the other hand, for outside experts who can assist community banks with such analyses and provide them with independent support to justify the specific capital levels they maintain, this may be a fruitful time.

It's amusing that while this story asserts that the stress tests are evidence that the regulators are moving toward "highly customized. portfolio specific" capital requirements, Warren Buffet and Charlie Munger complained a few weeks ago that the stress tests didn't make sense because they were a "one-size-fits-all" exercise that didn't take into account each bank's unique business characteristics. Of course, their remarks were made prior to the release of the tests, so maybe Warren and Charlie have changed their minds. They haven't said, although Buffet bought more Wells Fargo stock prior to the announcement that as a result of the stress tests, Wells Fargo had to raise an additional $13.7 billion in capital. As the Motley Fool pointed out yesterday, Wells Fargo's subsequent stock offering diluted Buffet's holdings (along with other common shareholders) by 9.2%. I imagine that Warren is even less of a fan of stress testing today than he was earlier this month.