The New Reality

The conclusion of the banking stress tests continued to dominate the economic news through the weekend. For many casual observers it was a conclusion that could not come fast enough. For months we have been told that the banks need fixing; we have lavished vast sums of taxpayer money on them; we have suffered through what seems like endless stories about bonuses; and then we had to twiddle our fingers while the stress tests took place. Now we can assess the new landscape and ask the crucial question: are the banks fixed?

No.

The principal economic policy objective from the beginning of the banking crisis has been to get the banks re-capitalized sufficiently that they can resume their role as engines supplying credit to consumers and businesses. That flow of credit will be essential if we are to establish a strong recovery.

Policy as pursued until now has failed to accomplish that goal. The amounts of capital the government has now instructed the banks to raise is insufficient to return them to robust health. Instead it merely moves them from the critical to the guarded list.

Under both Presidents Bush and Obama there has been an unfortunate bias towards avoiding the ‘heavy’ lifting necessary to clean the banks out of their rubbish and to get capital ratios up to ‘slump proof’ levels. Instead we have suffered through all sorts of ingenious and bureaucratically well crafted schemes that seek to avoid pressing too hard against the delicate fabric of finance in case it falls down. As if it hasn’t already.

Those of us who are disappointed at this policy record have to face the new reality: America will almost certainly have to go through another stimulus and bailout round before it gets a long term solution. Everything that has gone before has been an attempt to stall long enough for the economy to heal and thereby to heal the banks.

So the administration, if we judge it by its deeds rather than its words, has committed us to the long road. I suspect this is a very ‘Summers’ strategy. In essence the new reality is to accept the power of the banks; to accept the theories and worldview of the recent past; to avoid strong action that may have unforeseen consequences; and to attempt to spend as little as possible on the repairs. In short we are temporizing or buying time.

The belief in the administration is that the banks can ‘earn they way to health’ as long as the economy doesn’t fade away altogether. They have studied some of the lessons we learnt back during the S&L crisis of a couple of decades ago and concluded that a combination of lax accounting, steep yield curves, government guarantees, and minimally invasive surgery are all that is needed. That combination will provide that backdrop against which banks can expand profits and thus rebuild capital without any further government intrusion.

It is a very passive policy, born, I suspect, from a pessimistic reading of the political landscape.

“It is a very passive policy, born, I suspect, from a pessimistic reading of the political landscape.”

It is the new reality so we must accept it.

For those of you who disagree with my interpretation, here is the evidence I am going on:

1. The stress tests were, from the start, skewed in the bank’s favor. They were not really stressful enough. The most severe assumptions used on the most important variables in the test models – such things as unemployment rates – turn out to be pretty much where we are now. By implication then the tests assume things will not get much worse. That’s hardly stressful. The whole point of a stress test is to go to extreme limits and watch for the reactions of the person or company being tested. Their performance on the extreme is a guide to what will happen under much less severe circumstances. And it those less severe circumstances that we ‘expect’ to occur. But our tests didn’t do that. The banks were not pressed to the limit. We have no idea what would happen under a continued decline in the economy. Our forecasts were too benign. Why? Because we really didn’t want to know the ‘outlier’ problems. There was no need since we were committed a priori to only modest findings. The test were bogus. Bernanke himself has hinted at this: he has said he wanted to go down the ‘middle route’.
2. The banks negotiated the results. It has emerged that even the weak tests suggested that Bank of America needed to raise over $50 billion in capital. An outraged management succeeded in getting that lowered to about $34 billion. Was the test wrong? Or did they just bully the government? We don’t know. But the shift isn’t comforting.
3. The banks have already let investors know that the government has tacitly agreed to back off any coercion later this year if it turns out the banks have not raised the suggested amounts. That is if the banks have had good earnings this year. This confirms the notion that public policy is to allow then banks to earn their way to health.
4. The tests were based on bank generated rather than regulator generated risk models. These are the models that caused the crash, but apparently we are happy still to use them. That’s a bit like giving the kids who just crashed the family car the keys to its replacement without making sure they can drive any better.
5. Finally the Treasury Department has been slipping and sliding on the exact definition of capital it wants to use. It abandoned Tier 1 capital, the old ratio used since 1988, a long time ago to focus on plain old equity. This was supposed to be a ‘quality’ issue: Tier 1 includes all sorts of non-equity stuff like preferred stock that earns interest and so is a bit more of a burden than plain equity. It also is a bit sneaky: the banks can convert the government’s preferred stock and look like they’ve raised capital. Which in a Tier 1 world they haven’t. Now we find out that the Treasury is using something called ‘Tier 1 Common’, not the more restrictive ‘Tangible Common Equity’. Why? Who knows? Not even the Financial Times. The betting seems to be, though, that it gives the banks an edge up. Given the administration’s attitude, that seems like reason enough.

Given these snippets of evidence I stand by my conclusion: the new reality is to stand back and let the banks go back to whatever they were doing before so they can earn enough to generate or attract capital to plug the holes in their balance sheets.

The economy has to power the banks, not the other way round.

The implications?

• Slower growth. While the banks repair themselves they will not be very concerned in getting back to expansion. So new loans will be hard to come by and expensive.
• A renewed call for stimulus. Without healthy banks it is not clear where growth will come from, so it is likely unemployment will rise some more and peak above where it would have done had we fixed the banks more quickly. So by the end of this year the economy could still be languishing and in need of further stimulus.
• Banking will be less competitive. The crisis eliminated some players and hobbled others. Those that emerge strongly will be able to concentrate power even more than before. We will have even larger banks to contend with in the future, with an even greater fear of their size and ability to harm the economy.
• We will end up with some sick banks lingering well into next year, maybe beyond. That raises the chance that we may need fresh bailout money, and that the consequent expense will be higher than that had we taken more radical short term action.

Ultimately the administration’s unwillingness to confront the banks dictated this course of action. We have socialized losses and privatized gains relentlessly. There has been a huge transfer of wealth from taxpayers to shareholders and employees of banks. We have put at risk larger parts of the agenda many of us hoped the Obama would enact.

But that is the new reality. We must adapt. Let’s hope it all works out well.