What Stress Test?

Well the bank stress test results are in.  Yesterday, the Fed released the Supervisory Capital Assessment Program results and banks were only short, collectively, about $75 billion dollars.  A sigh of releif?  Our banking system is now safe? Well, lets take a closer look.

We already pointed out that the stress test was really a bank self-assessment.  Now if you take a look at the level of stress acceptable, you need to question the soundness of the system.  Historically, we have held banks to a leverage ratio between 8 to 12 to one.  These stress tests hold the bank to twice that - in other words the capital assets ratio is 25 to 1.  Barry Ritholtz Big Picture blog explained:

Consider this simple fact: 

Treasury and the Fed want these banks to have Tier 1 common stock equal to 4% of risk-weighted assets. In other words, 25-to-1 leverage as safe for the future.

Hence, it is not a big stretch to conclude that the entire stress test exercise is a near charade, with foregone conclusions of deleveraging banks to still wildly over-extended positions.

Recall that before the 2004 SEC Bear Stearns exemption for the 5 biggest investment banks, net cap rules limited leverage to 12-to-1 for investment banks.

Is 25-to-1 leverage appropriate for depository banks? Well, maybe before the repeal of Glass Steagal — but with today’s toxic asset laden banks, 25-to-1 seems awfully friendly

Why the free pass?  The answer is the banks can grow their way out of the mess.  Huh?  Grow their way out?  That is not the purpose of liquidity ratios.  What does that mean for depositors?  Get your money now before the bank runs or wait for the bank to grow its way out.