One part of the stress test seems to be a little problematic, for some. While the results revealed a $185bn shortfall in capital amongst the 19 biggest American banks, the SCAP will only need to replenish them with $75bn. Here are the relevant bits from Thursday’s announcement:
The SCAP focused not only on the amount of capital but also on the composition of capital held by each of the 19 BHCs. That is, SCAP assessed the level of the Tier 1 risk?based capital ratio and the proportion of Tier 1 capital that is common equity. The SCAP’s emphasis on what is termed “Tier 1 Common capital” reflects the fact that common equity is the first element of the capital structure to absorb losses, offering protection to more senior parts of the capital structure and lowering the risk of insolvency. All else equal, more Tier 1 Common capital gives a BHC greater permanent loss absorption capacity and a greater ability to conserve resources under stress by changing the amount and timing of dividends and other distributions. …
The $185 billion estimated additional capital buffers correspond to the estimate that would have applied at the end of 2008. But a number of these firms have either completed or contracted for asset sales or restructured existing capital instruments since the end of 2008 in ways that increased their Tier 1 Common capital. These actions substantially reduced the final SCAP buffer. In addition, the preprovision net revenues of many of the firms exceeded what was assumed in the more adverse scenario by almost $20B, allowing them to build their capital bases. The effects of these transactions and revenues rendered the additional capital needed to establish the SCAP buffer equal to $75 billion.
They key here, as the above notes, is the composition of the capital, not necessarily the amount. The stress tests’ focus on common equity instead of other types of Tier 1 capital means many banks will have to raise more of the former. A simple way of doing that is to convert the US government’s current preferred shares, which were issued in the Autumn as part of its banking bail-outs. That would help banks boost their common equity ratios but not necessitate further money from the government (read: taxpayers). Some pundits, however, see this as troublesome — or futile.
Here for instance, is Paul Kasriel of The Econtrarian (our highlight):
So bondholders aren’t better off but taxpayers aren’t really worse off — though, we should note, they probably won’t get dividends with common stock. Existing common shareholders will of course have their holdings diluted. Depending on where you sit in the financial system (taxpayer, banker, lender, shareholder, etc.) then, this may generate responses varying from “so what?” to “hooray” to the unprintable.
There’s one more point to make about converting preferred shares to common, aptly summed up by the San Francisco Chronicle:
One way banks could increase common equity is by converting the government’s preferred shares, which have no voting rights, into common shares, which do. Most banks are loath to go that route, however, because many executives and shareholders already complain the government has become too active in managing their businesses.
So depending on which side of the fence you sit (banker or taxpayer) you will likely have vastly different opinions about the potential conversion of preferred stock into common equity. Wells Fargo, for instance, reportedly plans to fill its near-$14bn shortfall through a $6bn secondary stock offering and earnings. Only if those fail will it consider converting preferreds into common stock. Bank of America, which needs the most capital, has explicitly said it won’t convert.
A novel new type of stock introduced in the SCAP, the mandatory convertible preferred share, could bypass the above control issue, however.
Related links:
US U-turn on tangible common equity – FT Alphaville
Tangible common equity for beginners – The Baseline Scenario
Fed and Treasury: Putting off hard choices with easy money – Hussman Funds