Have US banks jumped the shark?

America's banks are back on track with most passing the Fed's recent stress test. But with dangers on the horizon, decisions by bankers to abandon prudence and placate shareholders may yet prove to be a poor choice.

FT.com

Greg Smith did Goldman Sachs a fair bit of damage. But he probably did the rest of Wall Street a big favour. When the previously unheard-of Goldman Sachs banker penned an opinion piece in the New York Times this month – publicly resigning and condemning his employer for a craven corporate culture – it became the main topic of conversation among bankers and anyone with a passing interest in finance for days.

It also detracted from a less titillating news item – the publication the day before of the latest round of Federal Reserve stress tests on the country’s 19 big banking groups. On the face of it, the tests were a ringing endorsement of the repair work done on banks’ balance sheets since the financial crisis hit five years ago – 15 of the 19 passed the regulator’s tests even after factoring in planned dividend increases they have been itching to push through, at shareholders’ behest, for the past couple of years.

The outcome was embarrassing for Citigroup, the one big-name group whose dividend plans were blocked because they fell short of the passmark – a 5 per cent core tier one capital ratio under the stress scenario. But with a few other footnotes, the tests sent a clear signal – the US banking system is back in rude health.

Can we really be so sure? On the face of it the tests were tough. They included a sharp contraction of GDP, unemployment peaking at over 13 per cent next year, US equity prices slumping 50 per cent and US house prices falling a further 20 per cent. The Fed’s stress testing has often been hailed by critics of Europe’s copycat exercises as a model of how things should be done – far tougher, far more credible and, when coupled with an injection of emergency state "Tarp” money a few years ago, a recipe for financial recovery.

This time, with the heart of the financial crisis having shifted to Europe, it is risking complacency. Yes, the Fed modelled for an unspecified "growth slowdown” and a "very significant widening” of credit default swaps on both European sovereigns and financial institutions, as well as sharp increases in spreads on European sovereign bonds. But the Fed did not model for any sovereign default or for any of the economic doomsday scenarios that should arguably have been considered. The much criticised European Banking Authority – the pan-EU body in charge of Europe’s tests – took a tougher stance.

To judge US banks to be over the worst because their domestic market seems to be recovering is to underestimate the transmission mechanisms – notably unmonitored derivatives exposures – by which global banks can be laid low.

All the more reason for caution, then. Yet the US has stuck with a far lower pass mark for its stress tests than the EBA. The European regulator, much to the chagrin of the region’s banks, has demanded not only a 9 per cent core tier one pass mark but has also toughened the definition of capital according to so-called Basel 2.5 rules – a halfway house between Basel II, which the US has never implemented, and Basel III, which it is promising to.

If the Fed had imposed a 9 per cent pass mark, even without a tougher definition of capital, only three of the 19 banks – American Express, Bank of New York Mellon and State Street – would have passed. Worst of all is the net result of the Fed’s green light. Within hours, the big banks had announced sweeping plans to return vast sums of money to shareholders via dividends and share buybacks. JPMorgan alone announced it would buy back as much as $15 billion of stock and raise its dividend by one-fifth. Wells Fargo increased its quarterly dividend by more than 80 per cent.

US banks, understandably, feel hard done by, what with the restrictions of the Volcker rule, the complexities of the sprawling Dodd-Frank legislation and the imminent phase-in of Basel III. But all the more reason, surely, to build up capital buffers now and make an early and thorough transition to the realities of the new world. With the economic outlook in Europe – and globally – still so uncertain, it is too early to be eating into capital by distributing so much of it to investors.

It is not a problem that many banks in Europe have to wrestle with. Many are generating losses, or such anaemic profits, that dividends have been suspended or shrunk to the minimum. Committed dividend payers, such as HSBC in the UK and Santander in Spain, are having to create fresh equity even as they make payouts to existing shareholders.

It is an unpopular message for shareholders in the short term. But pretending that the world is fixed, and counting on profit accumulation to refill capital buffers over the next few years, is a gamble – either optimistic or reckless depending on how bleak your view.

Patrick Jenkins is the FT’s Banking Editor.

Copyright The Financial Times Limited 2012.

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