The US government's bank stress tests appear to have been successful in stabilising financial markets, but some market observers believe they are obscuring broader systemic problems and could hamper efforts to deal with toxic assets.
Carried out under the Supervisory Capital Assessment Program, the results of the tests were released on May 7. They found that 10 of the 19 banks assessed needed to raise a total of $74.6 billion, with Bank of America receiving the largest assessment of $33.9 billion.
The release of the results saw an initial rally in the market for financial stocks. From May 7 to market close on May 8, shares in the Financial Select Sector SPDR exchange-traded fund rose by 7.42% to $13.02, according to Bloomberg. Although they subsequently slid lower to $11.39 at close on May 13, shares in the fund closed at $12.28 on May 20.
According to some analysts, banks such as Morgan Stanley and Wells Fargo have had some success in raising common stock to meet the new regulatory minimum imposed by the tests. They require US banks to maintain a ratio of 4% Tier I common capital to risk-weighted assets for the next two years.
However, market participants emphasise that more fundamental risks continue to dog the financial sector. One indication of this is continued high volatility among financial stocks, according to Dean Curnutt, the president of New York-based derivatives strategy and execution firm Macro Risk Advisors.
He points out that the rolling ratio of six-month realised volatility of S&P 500 financials had typically been around 1.25 in the past. During previous crises, this ratio has increased. During the collapse of hedge fund Long-Term Capital Management in 1998, it went up to 1.6, he noted. More recently, when Lehman Brothers declared bankruptcy in October last year, it increased to 2.4. But since then, it has remained at elevated levels.
"Now, financial volatility is realising at 2.3 times the index. That means for a 2% move in the S&P 500 you often see nearly a 5% move in financials. That's not healthy. The financial crisis will not be over while the banks continue to look wobbly," said Curnutt.
In a note to clients on May 15, he and his colleagues criticised banks' first-quarter earnings - many of which were surprisingly upbeat - as being too heavily weighted towards one-off gains and investment banking activities.
"Looking at the most recent earnings reports, banks were able to beat estimates through low-cost debt issuance due to Federal Deposit Insurance Corporation backing, lower valuations on their own debt and trading revenues largely credited to large, price-insensitive unwinds of a certain insurance company's derivatives book," it said.
Far from helping to ease the broader problems facing banks, the stress tests could actually increase them, argued Jeffrey Rosenberg, the head of credit research at Bank of America in New York. "The stress tests have created an opening of the market for private capital. Where I'm reticent to give a wholehearted endorsement is that the deepening of that capital commitment is not a sign of market participant confidence in the financial system," he said.
Instead, he believes investor inflows are being driven by a belief that the government has essentially guaranteed the health of the 19 banks participating in the tests. In this sense, the government had "engineered a policy that creates moral hazard at its core", he remarked. The result, in his view, will be short-term stability at the cost of a protracted credit downturn and long-term economic performance.
Similarly, Douglas Elliott of the Brookings Institution, a Washington, DC-based think-tank, has warned the tests will work against initiatives aimed at getting banks to sell toxic assets, such as the Treasury's Public-Private Investment Program. "The government's reassurance that these banks have, or will soon have, the capital to handle even the stress scenario without selling their toxic assets makes it harder for the regulators to pressure the banks to actually sell," he said in a research paper on May 11. Furthermore, with banks eager to maintain their prescribed minimum capital ratios and avoid shareholder dilution, they would be hesitant to sell any assets at below par value, he added.
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