Financial Times Editorial Comment: Testing times for Geithner’s plans/How banks learnt to play the system

Financial Times Editorial Comment: Testing times for Geithner’s plans
Copyright The Financial Times Limited 2009
Published: May 6 2009 19:14 | Last updated: May 6 2009 19:14
http://www.ft.com/cms/s/0/6d7580a2-3a67-11de-8a2d-00144feabdc0.html


Some US banks are walking wounded. Some are the living dead. A full 21 months into the credit crisis, investors are still unclear about which banks are which. The banking system cannot function without confidence. So, Tim Geithner, the US Treasury secretary, is fighting chronic uncertainty with transparency. The results of the “stress tests”, an exercise to identify undercapitalised banks so the government can make sure they have enough capital to recover, will be announced on Thursday.

Regulators have examined the 19 biggest US banks. They have decided which of them they believe would be healthy – and which would lack sufficient capital to survive – under two different economic scenarios. Since, post-Lehman Brothers, bank bondholders are protected from bearing any losses, institutions with insufficient capital cushions will be forced to raise new equity, whether from private sources or from the public purse.

To make these judgments, the authorities have estimated banks’ future income, losses and the cost of bygone mistakes. To do so, they have made a number of contentious assumptions, notably about future macroeconomic conditions. Since the tests were announced in February, the authorities’ choice of scenarios has started to look optimistic – especially for unemployment.

These calculations also rely on assumptions about how the financial system’s stockpile of complex, illiquid, unpriceable assets will respond in these conditions. Few of these toxic securities were ever traded. Hardly any are bought and sold now. There are no real markets for these assets, so there are no reliable market prices. Indeed, the Treasury believes these anaemic markets are significantly undervaluing the securities and, so, prefers to back out prices from models.

Owing to the uncertainty and the capacity for disagreement at each of these steps, it is crucial that the authorities publish as much fine detail as they can. Unless analysts can follow regulators’ calculations, check their views on general asset classes and compare notes on specific balance sheets, worries about modelling assumptions may lead them to disregard the whole exercise. A vague rubber stamp will not be enough; if it undermines confidence in the government’s grasp of the crisis, it could even be worse than nothing.

The government is also choosing to judge capital need using a rather old-fashioned measure; the ratio of tangible common equity to total assets, rather than complex risk-weighted Basel capital measures. Tangible common equity is a crude metric, but it is what investors currently prefer. That is why it is the right measure for this purpose; TCE has the best chance of persuading investors that large American banks have enough capital to support their massive balance sheets. Restoring their confidence would be an impressive achievement. It would not, however, end the credit crisis.

Banks hold only about one third of the US financial sector’s outstanding loans. American consumers and businesses have relied heavily on still-frozen non-bank lending flows. Some of Mr Geithner’s many other policies aim to revive these markets, but, for now, they remain clogged. If the banks were to expand to fill in for these jammed credit markets, they would need trillions of dollars of further capital against which to lend.

Moreover, clean bills of health for banks would not mean markedly less government control of the financial sector. The Treasury has said banks will be allowed to repay government capital injections – and so escape the onerous terms and conditions attached to them – only if they are able to issue new debt without government guarantees.

Even if the state has no stakes in banks, however, government oversight of the sector will still be necessary. Big US banks are still backed by the government. The state, therefore, has a legitimate role in making sure that these institutions act prudently. Given the banks’ macroeconomic importance, the state must also make sure they do not act in a manner which would hurt the public interest, such as rapid, widespread deleveraging.

By the end of Thursday, the US will have revealed a great deal more about its banks than any other country. Even if investors are not convinced, applying a single standard to all banks and publishing detailed results will provide the market with useful information.

This is all in striking contrast to Europe’s reluctance to act. According to the International Monetary Fund, the US banks have another $550bn of writedowns to come; the equivalent figure for the eurozone and UK is $950bn. The real information gap lies not in Mr Geithner’s stress tests, but in Europe’s unwillingness to match them.



How banks learnt to play the system
By John Gapper
Copyright The Financial Times Limited 2009
Published: May 6 2009 20:02 | Last updated: May 6 2009 20:02
http://www.ft.com/cms/s/0/960a15d0-3a6e-11de-8a2d-00144feabdc0.html


Those who cannot remember the past, wrote George Santayana, are condemned to repeat it.

Twenty years ago, global banking regulators declared that every bank ought to hold core capital equivalent to 4 per cent of its risk-weighted assets. Today, the US government will say the same thing differently.

This repetition will be expensive. It may force Bank of America to raise an extra $34bn (€25.6bn, £22.6bn) of common equity, and Citigroup to raise up to $10bn. More than half of the 19 banks under scrutiny could be told to drum up capital.

The difference between 1988 and today is that tangible common equity is the new tier 1 capital.

To all but bankers or regulators, that last sentence is incomprehensible, of course. Yet it encapsulates why two decades of reform intended to protect banks against collapse not only failed to work but had the perverse effect of hiding the problem.

If governments want to do better this time, they must learn the lesson that banks faced with new balance sheet rules will expend an inordinate amount of time and effort trying to evade those rules. Indeed, the cleverer the rules, the greater the opportunity for financiers to arbitrage them. This is why investors have lost faith in tier 1 and prefer a more basic sum.

The stress tests on the largest 19 US banks carried out by regulators over the past couple of months, the results of which will be disclosed this Thursday, echo the 1988 Basel Accord. Basel I was the first effort by regulators to set capital adequacy standards for global banks.

The accord tried to do two things: to raise the level of capital held by banks – notably those in Japan – and to measure leverage (their ratios of capital to assets) better.

That was how the trouble started.

Banks are highly leveraged institutions that hold only a small amount of capital compared with their assets. That is what gives them their economic importance – they can lend far more to people and companies than their capital base – but also what makes them vulnerable.

A comparatively small loss in the values of assets, including commercial and residential property, during recessions can eat through the capital base of a bank, making it insolvent. This is what has occurred over the past 18 months.

Basel I attempted to address this by setting a maximum leverage ratio – or a minimum ratio of capital to assets – for global banks. That figure was 8 per cent, which is equivalent to allowing a bank to be leveraged a conservative 12.5 times.

If that was how leveraged banks actually were, we would not be in half this trouble. But some investment banks entered this downturn with capital-to-asset ratios of 30 times or more. That was because neither their assets nor their capital were what they seemed.

On assets, Basel introduced the notion of risk weighting, which essentially meant that some kinds of loans – for example, highly rated corporate bonds and, yes, residential mortgages – were considered less risky than others, so less capital needed to be held against them.

It was not a bad idea in principle but it set off two decades of financial engineering by banks to classify as many of their assets as possible as low-risk weighted in order to swell their balance sheets and so make a higher return on capital.

One of the puzzles of the financial crisis is why banks were caught with huge amounts of securitised mortgage debt when the point of securitisation – turning assets into securities – is to be able to sell loans.

Viewed through the Basel lens, however, the hoarding of securities made sense. By transforming 50 per cent risk-weighted mortgage loans into triple A securities, and with the help of rating agencies, banks reduced the amount of capital that they needed to hold against these assets.

A bit of insurance wizardry took the regulatory arbitrage further. Banks could cut their capital charge to near zero by laying off the credit risk of mortgage securities to AIG through credit default swaps. Hey presto, billions of dollars of assets absorbing virtually no capital!

On capital, Basel was not as strict as it sounded. The 8 per cent figure was split into two groups – tier 1 and tier 2 capital. Nobody talks much about tier 2 capital now because it is pretty flimsy stuff – it includes subordinated debt and other securities only distantly related to equity.

For years, regulators and investors have focused on tier 1 capital, which is made up of equity, preferred shares, goodwill and intangibles. Banks must hold a minimum of 4 per cent tier 1 capital to risk-weighted assets.

Yet even tier 1 is a loose measure of capital strength, since it includes preferred shares and other miscellany. In practice, it is a bank’s common equity that absorbs the losses from its troubled loans and assets.

The result of this relentless deflation of assets and inflation of capital is the absurdity that the banks the US will today instruct to raise billions more in equity are, by Basel standards, in rude health.

Bank of America, for example, had a tier 1 ratio of 10.1 per cent in the first quarter of this year, while Citi’s tier 1 ratio was 11.9 per cent. Both banks had between two and three times the minimum ratio.

It would be wrong to throw away the entire Basel framework (including the Basel II revision of 2004) because global banks found ways to game the system. There is still a place for broad measures of banks’ capital strength and risk weighting of assets.

But this Thursday’s stress test results are both a harsh judgment on the biggest US banks and a damning verdict on Basel and two decades of capital adequacy regulation. We should remember that.

john.gapper@ft.com

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