Positive stress for US banks

America's bank stress test results show why it's coping so much better than Europe. Had the eurozone been similarly stringent, the world economy would be in much better shape.

Overnight the US provided further evidence as to why, despite continuing weak economic conditions, it hasn’t descended into the economic and financial nightmare that is Europe.

The key issue that has bedevilled attempts to stabilise Europe has been the entanglements between the economies in the eurozone and the eurozone banking systems. Under-capitalised banks have massive exposures to the debts of troubled sovereign issuers, which means that the sovereign debt crisis in the region poses risks to the stability of its banking system.

The US could have been in the same position but its initial response to the global financial crisis included the imposition of stress testing of its banks that, with the benefit of hindsight, has proved to be quite stringent. Those tests forced the more thinly-capitalised US institutions to raise considerable amounts of capital – in the period since those first tests the banks have raised and generated more than $US300 billion of tier one capital.

Europe, of course, has had several rounds of stress testing of its own. Even without hindsight it was obvious that the initial tests had more spin than substance to them – the European Banking Authority tried to use them to shore up confidence in the banks and to buy time rather than using them as leverage to force the banks to recapitalise.

By the time the Europeans got serious last year and undertook a realistic assessment of their banks’ capacity to absorb stress – and discovered a capital shortfall (still understated) of about €115 billion – it was in the midst of a new crisis and it was obvious that the banks’ holding of supposedly risk-free sovereign bonds wasn’t risk-free at all, as the holders of Greek bonds and those on the wrong side of credit default swaps on those bonds have now discovered, painfully.

Last night the US Federal Reserve released the results of its latest round of stress testing. Four banks – including Citigroup and the largest insurer in the US, MetLife – failed the tests, which underscores their credibility.

The tests were based on quite scary scenarios: unemployment at 13 per cent, a 50 per cent fall in equity markets and a 21 per cent (further) decline in already-depressed house prices. The 19 banks tested would, under that scenario, lose about $US534 billion over the nine quarters of the scenario period. Another $US115 billion would be lost due to operational risks, fraud, systems failures, lawsuits and losses on mortgage repurchases.

Despite all that, the aggregate post-stress tier one capital ratio for the banks would be 6.3 per cent at the end of the imagined crisis (down from 10.1 per cent last year). Citigroup would only barely fail to meet the minimum 5 per cent minimum stressed ratios, with a tier one ratio of 4.9 per cent. (Citigroup would only fail the test if it proceeds with planned capital management initiatives. Without them it would pass comfortably).

The Australian Prudential Regulation Authority conducts similar tests on the Australian banks, with similarly demanding assumptions on unemployment, wealth destruction and housing prices.

Earlier this year a working paper by a couple of IMF researchers generated some controversy when it applied the experience of the Irish banks and the implosion in Ireland’s housing market to the Australian banks – very similar assumptions to those used in the US stress tests.

The Australian banks' tier one capital ratios would still be comfortably above the 5 per cent levels – three of the four majors would have ratios above 8 per cent and the other a ratio of about 6 per cent.

Even if a housing market crisis were overlaid by a spate of corporate collapses, costing the banks about 6 per cent of the value of their corporate lending and pushing them into losses, Australian banks might need to raise some tier one capital but would survive quite comfortably.

One of the speculated reasons that the Europeans have taken so long to come to grips with the crisis in Greece is that they needed time to work through the implications for their banks and ensure that they had sufficient funding to absorb heavy losses on their exposures to the weaker eurozone members.

The massive infusions of low cost funds from the European Central Bank – three-year funding at 1 per cent – would not only have helped the banks prop up the value of their sovereign debt holdings, and generated a profitable carry trade in the process, but given them the liquidity to absorb losses on their holdings of Greece’s debt, where investors – including the banks – are being forced to take a $130 billion or so 'haircut'.

Late last week, having ruled at the start of this month that the Greek bailout hadn’t triggered a credit event, the International Swaps and Derivatives Associated provided a fresh ruling that it had after Greece triggered ‘collective action’ clauses in the bondholders’ agreements to force them to accept the losses.

That in turn created a trigger event for the billions of euros of credit default swaps that have been taken out as insurance against losses on the Greek bond, although because banks will be on both sides of the swaps the net overall exposure is said to be quite modest and perhaps as little as €3 billion.

The ISDA ruling is a positive one for the future of the CDS market, which was under a cloud because of the prospect that Greece could force ’voluntary’ haircuts on the bond holders without triggering the CDS and therefore rendering them useless as insurance against loss.

If the net exposure to Greek losses among the European banks is small, and they have adequate liquidity to fund the gross payments that will flow through the system, the Europeans will have bought themselves more time to come up with a better and more permanent solution – and time for their banks to generate some profits and capital without having to call on already stretched national balance sheets for another bout of emergency taxpayer-funded assistance.

Had they emulated the Americans and conducted real and honest stress-testing during that relatively brief period between the easing of the initial global financial crisis and the outbreak of the secondary and very European-centric crisis last year, they – and the rest of the world – would be in considerably better shape today.

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