The Federal Reserve – which in addition to directing the U.S. monetary policy, also regulates banking operations in the United States – played a gigantic game of high-stakes “make-believe” earlier this year.
Specifically, they looked at the capital structures of 19 major U.S. banks, and tried to predict what would happen to them if the economy went through a rough patch.
The scenario: A theoretical 50 percent drop in stock prices, housing prices falling another 21 percent, a 13 percent unemployment rate, and a sharp recession in Europe.
The result: 15 banks survived the notional crisis – with the Fed dictating “survival” as success in maintaining tier-one capital ratios of at least 5 percent.
The failures included a few giants, though – most notably Citigroup, though it only failed by a very slim margin, falling to 4.9 percent tier one capital in the scenario.
The dog of the bunch was Ally, formerly the financial wing of General Motors. It would collapse to 2.5 percent tier one capital – just half of the Fed’s requirement. Guess who owns it? You do! This company came under the control of the U.S. Treasury Department after the auto bailout of 2010. Yay, team.
Other banks in the doghouse include MetLife (actually a bank holding company, but they’re in the process of changing that), and SunTrust Bank.
This is actually good news. The Fed seems to have been blindsided by the route of U.S. banks in the 2008-2009 crisis – and obviously the capital structures of so many of our financial institutions were grossly inadequate. Indeed, our investment banking industry – leveraged in some cases by as much as 30 to 1, was nearly wiped out.
The banks are squawking, of course, because the Fed was too mean. They objected to the Fed using a criteria that was more severe than the 2008 crisis itself.
This isn’t Ping Pong, though. The consequences of the failure of banks to maintain adequate capital reserves are severe. The U.S. government will not abide depositors paying the price for bank profligacy – but the resources of the Federal Deposit Insurance Corporation are paper thin compared to the potential liability. The FDIC can afford to take over the odd small bank and make depositors whole, no problem.
But if Citigroup and SunTrust both went under, it would take a lot of smaller players with them – and overwhelm the resources of the FDIC. We were lucky last time. Citi and Bank of America held together, and were even able to buy up the resources of some troubled banks. We were able to have Chase take over Washington Mutual. It may not be so easy next time.
But there is a price to be paid for this kind of caution: Banks will certainly read the tea leaves and work to shore up their tier one capital – at the expense of lending. And our economic recovery depends, in part, on a prudent revival of our credit markets. Less lending means further pressure on home prices, for example.
The Fed is also firing a shot across the bow at any bank considering boosting its dividend payments to shareholders, or for engaging in a share buy-back program. This won’t be great for shares of bank stocks going forward, though it’s not the end of the world – unless all you own are bank stocks.
If that’s the case, though, we need to talk about diversification.