Qualitative Squeezing

The Federal Reserve’s annual review of Financials’ health finally ended Wednesday with the release of Comprehensive Capital Analysis and Review (CCAR) results. Fundamentally, most banks look fine, with balance sheets weathering the Fed’s hypothetical storm—but in a bizarre twist, four failed for “qualitative” reasons. Apparently after years of ramping up regulation, the Fed has to rely on subjective measures to officially decide if banks’ future plans are viable. In our view, the irony here tells you everything you need to know about the effectiveness of five years of regulatory overhaul. On the bright side, the Fed’s feelings aren’t a great reflection of Financials’ fundamentals—measurable factors paint a much different (and better) picture.

CCAR was Part II of the stress test fiesta that began last week. Then, the Fed weighed banks’ potential durability during a hypothetical financial crisis of arbitrary magnitude and duration. This week, it used the CCAR to determine if their proposed dividends and share buyback plans are viable for the next nine quarters without risking the institution’s safety, even in crisis. 25 of 30 banks passed fine, though a couple had to revise down their dividend plans for final approval. One bank’s failure was expected: Zions failed last week’s stress tests—a prerequisite for the CCAR. Why the other four failed was much less clear. They passed the stress tests with flying colors. Quantitatively, these banks are in good shape—the Fed held them up for qualitative reasons.

What that means no one really knows. Even the failing firms are left in the dark—the Fed hasn’t disclosed details. CCAR official statements define qualitative factors as: appropriateness of the firm’s capital and risk planning and analysis in the capital proposal, if the proposal would be unsafe for the business or noncompliant and supervisory issues. But what exactly constitutes that is anyone’s guess—the Fed is deliberately vague, arguing it prevents banks from “studying for the test,” as if the banking business were equivalent to SAT prep. But where they see a test with more integrity, most see opacity—an exercise where anything the Fed feels is bad about the business could count against them. Sounds like what Standard & Poor’s would call “puffery,” if you ask us, but we digress.

When did official “feelings” become on par with fundamentals? Fundamentals are measurable. Anyone can look at a bank’s balance sheet and financial results and get a sense of the institution’s strength and viability. That’s transparency, and transparency breeds confidence. Opaque, shadowy regulatory tests without publicly available methodology or criteria only raise questions.

It wasn’t supposed to be this way. After the financial crises, regulators and central bankers loaded up on safety measures, hoping to create a better, more stable and transparent financial system. Now, having rules in place in case of crisis is all fine and well intentioned. But too many rules make regulatory systems complex, hard to understand (never mind follow) and, sometimes, self-contradictory—it creates more uncertainty, and risks regulators’ credibility, if not their ability to do their j-o-b. The Fed’s failing banks for qualitative reasons even after they passed the quantitative test seems like a tacit admission of this: All their standards, guidelines, etc., don’t help them regulate or even make the system any better. So they have to resort to opinions and subjective factors to determine whether a bank is safe.

This isn’t a US-only phenomenon—in its latest meeting statement, the Bank of England’s (BOE) regulatory body, the Financial Policy Committee, admitted these exact problems:

Contingent convertible debt, bail-in bonds, enhanced liquidity buffers, ring-fencing, subsidiarisation, counter-cyclical capital buffers, the list of reforms is endless and how it will all work when the worst happens, no one knows.

This raises several (currently unanswerable) questions for US and UK Financials moving forward. Will officials eventually deregulate to establish a transparent regulatory system they and everyone else can understand? Will they actually define those “qualitative” measures? Do something else? Who knows! Maybe the blowback blows over and the status quo persists. So far it’s all just noise and not actionable—speculation is premature—but if the chatter persists, the next four years of Basel III phase-in could get a bit more interesting.

What’s more important in the meantime is Financials’ balance sheets are in their best shape in a good long while. In part this is due to increased regulatory standards (a slight silver lining), but firms also bulked up quite a bit on their own, wanting to stay viable post-2008. Tier 1 capital ratios have increased from an average of 5.5% ($511 billion) to 11.6% ($971 billion) over the last five years. Charge-offs—the percentage of outstanding loans banks expect won’t be recovered—have fallen from 3.14% to 0.59% from Q4 2009 to Q4 2013. Banks’ return on equity has reached a healthy 9.48%, and return on assets 1.06%—both returning from negative rates at the end of 2009. And nonperforming loans are only 2.68% of all outstanding loans (versus 2009’s 5.01%).ⁱ

Mighty fine fundamentals, in our view! That the Fed and BOE can’t seem to accept this—and are scared undefined qualitative reasons might pull some banks under if they (gasp!) return cash to shareholders—says more about the regulators than it does about the banks themselves. For stocks, however, fundamentals (not feelings) weigh more long term.