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What Does Stress Testing of Banking Mean?

What Does Stress Testing of Banking Mean?

In recent financial news, Ben S. Bernanke, the chairman of the Federal Reserve, was quoted as stating that a stress test of the top 20 banks would occur. What this entails has been briefly outlined in the recent NY Times (online) article Stress Test for Banks Exposes Rift on Wall St. – NYTimes.com.

Note: Any emphasis shown in italics has been added by John Doughtry.

“Until the financial system deteriorated last fall, investors focused on what is known as Tier 1 capital, which [sic] consists of common stock, preferred stock and hybrid debt-equity instruments.

Now, however, they are focusing on what is called tangible equity capital, which [sic] includes only common stock, saying it is a better way to measure the risk in bank shares.

The difference might sound like something only an accountant would worry about, but it lies at the heart of two questions confounding both Washington and Wall Street: Are the nation’s banks sound? And are bank shares a good barometer for the health of the financial system? […]

Details of the bank stress test are scant, but federal regulators are expected to examine the ability of banks to cope with a situation in which unemployment rose to 10 to 12 percent and home prices declined by an additional 20 percent, according to Treasury Department and Federal Reserve officials. While officials say they don’t expect such a severe downturn, some economists aren’t ruling one out.

In recent weeks, federal regulators were planning to continue to demand that banks maintain Tier 1 capital equivalent of at least 6 percent of total assets adjusted for risk. Regulators also want at least half of it in common stock, but have given banks some leeway. […]

But stock investors are homing in on tangible common equity. Whereas Tier 1 capital gives regulators comfort because it captures a bank’s ability to weather a financial storm, stock investors, who suffer the first losses, are worried about their own exposure. Tangible common equity, or T.C.E., they argue, is the best measure for them.

Until last fall, there was little difference between the two measures. But when the government made big investments of preferred stock to shore up banks, common shareholders became more vulnerable.”

The Difference between Tier 1 Capital and Tangible Common Equity (TCE)

According to economist Dr. James Kwak:

“One commonly used measure of capital is called Tier 1 Capital, which includes common shares, preferred shares, and deferred tax assets. A less commonly used measure is Tangible Common Equity (TCE), which includes only common shares. Obviously, TCE will yield a lower percentage than Tier 1.

[…] The initial government investments in Citigroup, back in October and November, were in the form of preferred shares. Between the two bailouts, the government put in $45 billion in cash and got $52 billion in preferred stock (the $7 billion difference was the fee for the guarantee on $300 billion of Citi assets). That preferred stock was designed to be much closer to debt than to equity: it pays a dividend (5% or 8%), it cannot be converted into common stock (so it cannot dilute the existing shareholders), it has no voting rights, and it carries a penalty if it isn’t bought back within five years. In fact, it is hard to distinguish from debt, except perhaps for the fact that, if Citi defaults on it (cannot buy the shares back) we don’t need to worry about systemic instability, because the government can absorb the loss. As preferred stock, these bailouts boosted Citi’s Tier 1 capital, but not its TCE.”

The last sentence in italics is the key to understanding why TCE is a better measure of a bank’s health for share holders. It removes significant risks in measuring the capital worth of a bank, thus investors prefer to view TCE rather than Tier 1 measurements.

The bad news for the general public (whose tax dollars were used to buy the preferred stock) is that there is higher risk involved. Note, however, that unlike common stock, preferred stock does not provide as much control over banks, although the federal government, due to its massive presence, could attempt to bully bank executives. Considering the amount of corruption uncovered and the level of executive greed in the face of financial crisis, perhaps a full-time government watchdog is not a bad idea.

For those that have fears that these preferred stock purchases equate to a nationalization of our banking system, this should alleviate at least some of their fears.

Blog author: John Doughtry

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