Most of the major banks passed the financial stress tests with flying colors last week, in no small part thanks to some key concessions by the Federal Reserve.
Chief among them, the Fed downplayed the risks of the trillions of dollars of derivatives that banks still hold on their books. These complex derivatives, including exotic financial instruments like collateralized debt obligations and structured investment vehicles, played a key role in nearly bringing down the global financial system last fall. The banks got some help last month after forcing FASB to hastily issue a set of revisions in fair value and mark-to-market accounting standards, giving them license to inflate the value of billions of dollars worth of dubious assets. That helped pump up their quarterly earnings reports and their share prices, at least for the time being.
The Fed too apparently paid a lot of attention to the negative feedback it got from the banks after it informed them of the disappointing results of their preliminary stress tests. Banks such as Citigroup, Wells Fargo and Bank of America protested the deep capital holes forecast by bank examiners under the worst-case scenarios assumed by the stress tests, according to last Saturdays Wall Street Journal, and they succeeded in convincing the Fed to use a different measurement of bank capital levels than analysts and investors had been expecting.
The banks claimed they would be able to grow their revenue enough to compensate for these anticipated losses and cut costs aggressively enough to cover all those gaping holes on their books. One bank chairman reportedly called the stress tests asinine.
That back-and-forth may have made the stress tests more credible, at least in the bank executives minds, but they should give investors and accountants pause. The capital hole for Wells Fargo reportedly shrank from $17.3 billion to $13.7 billion under the original test scenario, according to the Journal, while Bank of America pared its gap from over $50 billion to $33.9 billion, and Citigroups went from about $35 billion to $5.5 billion. Smaller banks benefited as well, with Fifth Third Bancorp paring its estimated capital deficit from $2.6 billion to $1.1 billion.
The results of the financial stress tests also had the effect of relieving the stress of anxious investors. They greeted the news of the not-so-bad results with a wave of purchases of financial stocks. Confidence is a delicate thing, and the Feds role seems to have morphed in the past year as it works hard to stem the financial crisis. No longer is the main priority adjusting interest rates and controlling inflation. Now priority one is calming the panicky financial markets and keeping the banks from going bust.
