Much has been made of the bank “stress tests” which have focused on TCE (Tangible Common Equity) ratios. Top-notch bank analyst Tom Brown rightly declares the regulators’ obsession with these ratios to be “insane.” In his article on the Bankstocks blog Brown points out that the practical application of the stress test will result, not in net new capital in the system, but merely a conversion of the government’s preferred TARP stake into common, making the government a significant shareholder in these institutions. Although not explicitly noted in the piece, this will make it even harder for these institutions to ever attract real net new capital as private capital becomes increasingly wary of partnering with a capricious government shareholder.
At the end of the day, if the banking system truly needs new capital, it can: 1) simply inject more taxpayer money, 2) raise more private capital for existing institutions, 3) raise capital for new institutions, or 4) retain earnings over time. Option #1 is a political non-starter, and #2 won’t work since the government’s involvement in marginal institutions scares off capital. This leaves the possibility of #3, creating new banks , or letting existing problem banks earn their way out of trouble. The government appears to be favoring the latter — the problem is that this is a slow and painful process. Moreover, there’s a good case to be made that without being able to raise capital, operating earnings, excluding loss provisions, may not get much better — the current environment offers great spreads based on low costs of funds and lots of pricing power on the lending side — that still leaves plenty of room for profits, but maybe not profit growth over the long term, particularly if we get to the point where the Fed needs to tighten. Creating new banks is an interesting idea, but most de novo bank creation occurs at the community bank level and is inconsequential from the perspective of the entire industry. Significantly adding capital to the banking system through the creation of new entities could only occur if legislative changes ease the rules to permit the rest of corporate America into the banking arena. There seems to be little support for this — some may remember how quickly WalMart’s attempts to move in that direction were thwarted.
At the end of the day, the stress test will do nothing to enhance the position of the banking industry. The government’s new role as a large common shareholder may deter, rather than enhance the ability of troubled institutions to raise capital. This means that we will continue on the path of creating Zombie Banks, the “living dead” of the financial world, not allowed to die, but to0 weak to lend robustly.
The harm of Zombie Banks goes beyond simply tying up deposits in instutions that can’t lend. Zombies hamper the stronger institutions, precluding them from growing market share or gaining pricing power. Are we truly headed down this dismal road? The Federal government is providing the lifeline that sustains the Zombies through the Temporary Liquidity Guarantee Program (TLG), which provides government backing not only to certain debt issued by banks, but critically also guarantees, without limitation, low interest bearing checking accounts. This last provision indeed prevented a run on banks by corporate treasurers, whose deposits exceeded traditional FDIC limits. Last fall this may have been necessary since there was general distrust of the whole system. I would argue that this backing is now counterproductive — let the market decide which banks deserve uninsured deposits. Perhaps this could be done in an orderly fashion by gradually limiting the protected amounts (e.g., only deposits under $5 MM are guaranteed, etc).
The unlimited deposit protections of the Temporary Liquidity Guarantee Program are due to expire on December 31. Investors should watch to see whether this “Zombie lifeline” is extended. Deadline extension alone may ultimately not be the only action — if we ever get the Fed raising rates again, the TLG’s coverage of only low-interest accounts could result in disintermediation to money market mutual funds unless the guarantees are extended to higher interest deposits. Any extension of the TLG signals that we are not yet facing the risks of Zombie Banks. As long as these Zombie Banks walk among us, the prospects for robust economic growth remain dim and distant.