The Fed Says The Banks Are OK…But Are They?
Wednesday afternoon, after the markets had closed, the Federal Reserve released its latest “Stress Test” on the nation’s major banks. The Fed likes to release major reports after trading for the day is complete. That’s because they’re never quite sure how Wall Street will react. Significant reports, like this Bank Stress Test, can send markets into a tail-spin if the news is perceived as bad.
But no worries, this week, both the Fed and Wall Street were on the same page, namely that American Banks are doing just fine, thank you. To use the Fed’s own words:
“The Federal Reserve Board on Wednesday released the results of its annual bank stress test, demonstrating that large banks are well positioned to weather a severe recession and continue to lend to households and businesses even during a severe recession.”
The Street rallied, and the Fed breathed a massive sigh of relief as the Report had served its primary mission: assure the American Public.
So if you’re like me, you may be surprised at such a rosy outlook for the banks. After all, didn’t three of the four top four bank failures occur earlier this year when First Republic, Signature, and Silvergate Bank all when under? Although all three banks had a different client mix and provided various financial services, Signature, and Silvergate, for instance, were heavily involved in the Crypto Markets. In contrast, First Republic had more traditional Wealth Management advice. They all had two things in common, which led to their downfall.
First and foremost, each Bank was doing well, substantially expanding the Bank’s assets. It required the banks to shore up their capital. So, following the Federal Reserves’ own advice of 2019, the Banks loaded up on US Treasuries. In 2019, the Fed advised all the banks experiencing growth that investing in Treasuries was the easiest and most convenient way to add capital.
It may have been sound advice while interest rates were steady, but as soon as the Fed started raising interest rates, that dropped the value of those Treasuries. Bonds move inversely to interest rates; as rates go higher, the value of the bonds declines. And all three banks, as well as many others, saw the value of their capital steadily declining as the Fed continued to hike interest rates.
Now, the three banks: Signature, First Republic, and Silvergate, might have barely survived, except for one final event: a bank run. Each Bank experienced tremendous withdrawals during March. The two Crypto Banks, Signature and Silvergate, saw depositors flee in response to the failure of the FTX Crypto Exchange. In contrast, First Republic saw deposits vanish because of some adverse investment reports.
But no matter their motivation, in today’s electronic world, deposits can disappear quicker than you can imagine. At the push of a button, depositors move to a safer bank, and the original Bank is caught high and dry. That’s because deposits can offset loans, and if deposits decline, the Bank must come in with more capital to support those loans.
And remember, the original capital for the banks was declining because of higher interest rates. It was a double bind for the banks; higher interest rates meant that their in-house reserves were worth less, while the bank runs required that they bring in additional capital to meet the run. And in the end, they could not bring in money fast enough to meet their requirement. It was that lack of capital that sank the banks.
Aside from criminal fraud, this is almost always how banks fail; they simply cannot get enough capital in-house to meet such circumstances as excessive withdrawals (a bank run), loan defaults, or declines from their Capital Desk (US Treasures).
The difference between how the regulators treat these three mid-level banks and how the big four banks are treated is profound. For instance, in the Great Financial Crisis of 2008–09, Citigroup was allowed to function for nearly two years without the capital required.
Citibank was functionally bankrupt but was ultimately bailed out by the US Government, as they were: “Too Big To Fail.” We can argue whether this was a necessary step to prevent a total system-wide collapse; the fact remains that there are two sets of rules in the banking industry.
So with that background, let’s take another look at this year’s Fed Stress Test. Remember, this year’s Stress Test sought to discover how the 23 top banks in the Country would perform if the economy went into a “Severe Recession.” They measured the results of this recession in three dimensions: Commercial Real Estate declined by 40%, Residential Real Estate fell by 38%, and unemployment rose to 10%.
In other words, the Fed measured how the banks would perform if their loan portfolios were “hit.” If commercial, residential, and consumer loans saw higher levels of default. Another way to look at this is: how would the banks do if they suddenly had less income. Remember, all those loans provide income to the banks in the form of loans or mortgage payments. So the Fed’s Stress Test measured how the banks would perform with less income. And the good news, they would continue to operate just fine.
Cut, print, and write the headline!
It was an OK Test, but it had little to do with today’s reality. The three banks that failed this year were not put out of business because they needed more income. They went out because the underlying business model changed and changed almost instantly. Income wasn’t the issue; having the regulatory chair kicked out from under them was the issue.
In less than six months, the Fed’s Interest Rate Hikes had already put the banks in a highly tenuous position. Each Fed hike caused their capital, principally US Treasures, to decline in value. All it took after that was an electronic bank run to provide the final “coup de grace,” and the banks were done.
Fortunately, in this year’s “Stress Test,” the Fed didn’t go there! Wall Street, after all, wasn’t looking for that answer.
Wall Street got what it always wanted, assurance.
**
Follow me here on Medium for more stories from the ValueSide.
