The Sunshine Report

It is amaz­ing that Geithner’s pro­posal to “stress test” banks is mak­ing news as new pol­icy. After all, reg­u­la­tors were sup­posed to be doing this all along. After the last bank­ing cri­sis in the 1980s bank­ing reg­u­la­tors got the author­ity to antic­i­pate cap­i­tal short­falls as well as oper­a­tional defi­cien­cies. When prob­lems are iden­ti­fied reg­u­la­tors are sup­posed to man­date cor­rec­tive action well before a bank is in real trou­ble. “Prompt cor­rec­tive action” (or “PCA”) is the reg­u­la­tory jar­gon to describe the reg­u­la­tory author­ity that has existed for years but appar­ently not used recently. Geithner’s announce­ment that reg­u­la­tors are going to “stress test” banks is a nice polit­i­cally cor­rect way of say­ing that enforce­ment of safety and sound­ness rules is back in style and self reg­u­la­tion is out.

The Fed­eral Statutes man­dat­ing prompt cor­rec­tive action and the FDIC Risk Man­age­ment Man­ual of Exam­i­na­tion Poli­cies con­tain the author­ity for stress test­ing that bank­ing reg­u­la­tors had but didn’t use.

The Fed­eral Statute sets forth five dif­fer­ent cat­e­gories of cap­i­tal ade­quacy begin­ning with “well cap­i­tal­ized” to “crit­i­cally under­cap­i­tal­ized” and gives reg­u­la­tors dis­cre­tion to deter­mine the stan­dards for each cat­e­gory. The statute pro­vides that reg­u­la­tors can use sub­jec­tive cri­te­ria of safety and sound­ness to reclas­sify banks regard­less of the numer­i­cal cal­cu­la­tion of cap­i­tal adequacy.

Insti­tu­tions that don’t meet safe and sound cap­i­tal stan­dards can be required to raise addi­tional cap­i­tal, restrict both bank­ing and non-banking activ­i­ties, stop the pay­ment of div­i­dends and cut senior exec­u­tive com­pen­sa­tion. Also, reg­u­la­tors may require divesti­ture of assets and sub­sidiaries and can force banks to fire direc­tors and offi­cers that the reg­u­la­tors decide have done a bad job.

By the way, has any­one heard of a sin­gle offi­cer or direc­tor that has been fired at the request of the reg­u­la­tors? Also, dur­ing 2007 and most of 2008, how many big banks that were los­ing hun­dreds of bil­lions of dol­lars were required to cut their div­i­dends so that they didn’t pay out to share­hold­ers cap­i­tal that they would later need?

The FDIC Risk Man­age­ment Man­ual has lan­guage stat­ing that banks should have cap­i­tal to cover mar­ket risk and future changes in value and cred­it­wor­thi­ness of assets. In fact, the Risk Man­ual says that banks should be run­ning their own risk mod­els to make sure that they have enough cap­i­tal for future con­tin­gen­cies and that the reg­u­la­tors should be exam­in­ing these mod­els and the results.

Below are a few quotes from the FDIC Risk Man­age­ment Manual.

“Gen­er­ally, a finan­cial insti­tu­tion is expected to main­tain cap­i­tal com­men­su­rate with the nature and extent of risks to the insti­tu­tion and the abil­ity of man­age­ment to iden­tify, mea­sure, mon­i­tor, and con­trol these risks.

It is impor­tant to note that what is ade­quate cap­i­tal for safety and sound­ness pur­poses may dif­fer sig­nif­i­cantly from min­i­mum lever­age and risk-based stan­dards and the “Well Cap­i­tal­ized” and “Ade­quately Cap­i­tal­ized” def­i­n­i­tions that are used in the PCA reg­u­la­tions and cer­tain other capital-based rules. The min­i­mums set forth in the lever­age and risk-based cap­i­tal stan­dards apply to sound, well-run insti­tu­tions. Most banks do, and gen­er­ally are expected to, main­tain cap­i­tal lev­els above the min­i­mums, based on the institution’s par­tic­u­lar risk pro­file. In all cases, insti­tu­tions should main­tain cap­i­tal com­men­su­rate with the level and nature of risks to which they are exposed, includ­ing the vol­ume and sever­ity of adversely clas­si­fied assets.”

“The cap­i­tal ade­quacy of an insti­tu­tion is rated based upon, but not lim­ited to, an assess­ment of the fol­low­ing eval­u­a­tion factors:

• The level and qual­ity of cap­i­tal and the over­all finan­cial con­di­tion of the institution.
• The abil­ity of man­age­ment to address emerg­ing needs for addi­tional capital.
• The nature, trend, and vol­ume of prob­lem assets, and the ade­quacy of allowances for loan and lease losses and other val­u­a­tion reserves.
• Bal­ance sheet com­po­si­tion, includ­ing the nature and amount of intan­gi­ble assets, mar­ket risk, con­cen­tra­tion risk, and risks asso­ci­ated with non­tra­di­tional activities.
• Risk expo­sure rep­re­sented by off-balance sheet activities.
• The qual­ity and strength of earn­ings, and the rea­son­able­ness of dividends.
• Prospects and plans for growth, as well as past expe­ri­ence in man­ag­ing growth.
• Access to cap­i­tal mar­kets and other sources of cap­i­tal, includ­ing sup­port pro­vided by a par­ent hold­ing company.”

Hmmm…this isn’t a lot dif­fer­ent than stress test­ing to make sure that cap­i­tal is ade­quate in banks. Exam­in­ing risks to make sure that there is ade­quate cap­i­tal is, by def­i­n­i­tion, a “stress test­ing” exer­cise of future con­tin­gen­cies and loss scenarios.

It’s great that the Obama Admin­is­tra­tion is try­ing to not to per­form “witch hunts” of pre­vi­ous gov­ern­ment action (or inac­tion) and is also avoid­ing inflam­ma­tory par­ti­san lan­guage. But, Mr. Geithner’s announce­ment about stress test­ing banks makes me won­der what reg­u­la­tors were doing for the last few years. Polit­i­cally cor­rect Trea­sury action isn’t going to change the fact that reg­u­la­tors didn’t aggres­sively enforce cap­i­tal ade­quacy rules and instead tried “self reg­u­la­tion”. But, self reg­u­la­tion wasn’t the law that reg­u­la­tors were sup­posed to fol­low and even worse if just a plain dumb idea.

I applaud Mr. Geithner’s polit­i­cally cor­rect and non-confrontational announce­ment restor­ing enforce­ment of estab­lished rules as a pri­or­ity for reg­u­la­tors and am glad that he did it quickly after tak­ing office. The econ­omy doesn’t have a lot of time left to waste.