Banks that lend to private enterprises and small businesses are required to hold more capital than those that invest in government bonds. While getting banks to maintain higher capital reduces the possibility of a crisis-driven bailout from taxpayers, the crackdown on private lending will curtail the flow of business both within and outside the U.S., affecting the nation's long-term economic growth. Large parts of the financial community are rife with fears that the Federal Reserve's lack of transparency in how it assigns loss rates, for the banks on its radar, will further crimp credit supply.
For instance, CoMerica (NYSE: CMA), which is an active private lender, must hold $3 more in capital reserve for every dollar in assets, compared to the Bank of New York Mellon (NYSE: BK), which has a much smaller portion in private client assets, an analyst explained anonymously.
Under the Federal Reserve's proposed capital reserve regulations, U.S. banks are compelled to strengthen their capital buffer by holding more money in reserves -- at least 7 percent of their loans and investments, adjusted for risk, compared to the earlier mandate of 5 percent of risk-weighted assets as a portion of capital.
The problem with the Federal Reserve's bank capital requirements, based on risk-weighted assets, is its failure to take cognizance of inevitable differences in the types of assets that various banks own. Government bonds like Treasuries are not included in the calculation of risk weightings for bank assets. As a result, banks that hold Treasuries do not face stringent capital rules. While these investments benefit the government, banks that lend to private businesses get penalized, some analysts point out.
This must be changed. Money is seeping away from the private sector, said Richard Bove, an analyst at Rochdale Securities, which is based in Florida. The government is getting money that should have gone to the private sector.
The Federal Reserve's parameters for judging banks will have a telling effect on the banks' balance sheets and the ability of these institutions to manage their assets, said David Knutson, a Chicago-based analyst at Legal and General Investment Management, a European institutional asset management and investment firm.
Secondly, banks have been complaining about the lack of a fair play because of the Federal Reserve's refusal to disclose its criteria for estimating potential losses as a part of its stress tests. Mandated by the Dodd-Frank financial services law enacted by Congress in 2010 to keep an eye on systemic risk, these stress tests first came into force after the 2008 financial meltdown, which saw the collapse of Lehman Brothers and AIG.
The loss rates that the Fed applied to banks in its latest round of stress tests released in March this year have raised several eyebrows in the financial community, also sparking tensions between U.S. bankers and supervisors. Four of the 19 participating institutions, including SunTrust and Citigroup, fell short of the 2012 stress test on some measures. Citigroup slid 0.1 percent below the minimum capital requirement of 5 percent when the Fed factored in its proposal to buy back shares and pay out dividends to its shareholders. The Federal Reserve applied a loss rate of 23.4 percent on Citigroup -- a rate that was mysteriously double what it was during the last cycle and four times the median rate of all the 19 bank-holding companies that had been tested.
A stress test exercise conducted by Barclays Capital replicating the Fed's in early March this year resulted in different outcomes after banks were ranked on the basis of their loan portfolios, credit quality, assumed loss rates and revenue forecasts in hypothetical adverse scenarios. Interestingly, Sun Trust did the worst on our test as well as the Fed's. But we were off on Citi, said Jason Goldberg, a senior Barclays Capital analyst who led the team that ran the mock test. I don't understand how the Fed got the loss figures, particularly for Citi, he added. It would be great to get more detail on how they arrived at those numbers.
While the Fed has been urging banks to evaluate their own capital so that they may embrace the practice of developing internal risk models, analysts have been questioning why the banks' stress test results and those of the Fed are so disparate.
Significant differences between the Fed's stress test methodologies and those used by participating institutions are generating wide uncertainty, Vikram Pandit, Citigroup Inc. CEO and a member of the advisory council, indicated in a memo last month in the face of requests by U.S. bankers sitting on the Federal Advisory Council, to supervisors, to address the confusion that the latest stress test brought in its wake.
The Fed's clandestine approach to estimating banks' potential losses in its capital reviews stems from an in-built aim to protect its own credibility and dodge questions from analysts, said a bank analyst who asked not to be identified. This lack of straightforwardness could hurt markets by scaring investors away.
A key component of the Federal Reserve's stress test methodology involves viewing different loan portfolios with varying underwriting characteristics and degrees of risk. Analysts have invariably been challenging the regulator's assumptions of portfolios in similar business lines.
The Fed exercises discretion in its loss rate calculations because they want to avoid such a situation, Knutson said. It's like disclosing a source code for tech companies.
All 19 banks will need at least $50 billion in reserves to meet the capital cushion regulations that the Fed is currently proposing. New Federal Reserve rules also emphasize the need for banks to hold more high-quality capital -- bank assets that carry lower levels of risk.
While the Federal Reserve says it seeks to bolster its supervision of increasingly complex financial firms, its relationships with these institutions is festered with the huge impediment of an operational arbitrage, where how the Fed views its markets is starkly different from how the banks view their businesses, financial experts say.
Banks like Citi and JP Morgan manage their books and businesses globally, said Fred Sommers, lead partner of Basis Point Group, a capital-market consulting firm based in Boston. Regulators look at how those activities affect their national markets. There is therefore a fundamental disconnect.
The Fed's new rules will be phased in next January, if it wins the seal of approval from other regulatory agencies.