Capital Stress Tests Are Credit Positive for US Banks, but Exclude Most Problem Banks

Capital Stress Tests Are Credit Positive for US Banks, but Exclude Most Problem Banks

Last Tuesday, the Federal Deposit Insurance Corporation (FDIC) announced a proposal that would require state-chartered US banks with assets over $10 billion to conduct annual capital adequacy stress tests. This proposal, mandated by the Dodd-Frank Act, is essentially a carbon copy of the Federal Reserve’s recently announced stress test proposal for large US bank holding companies.3 The tests, and the requirement that banks publish their results, are credit positive because they will promote capital retention and support banks’ access to the capital markets. However, the $10 billion cut-off mandated by Dodd-Frank has a glaring weakness: it excludes the smaller community banks that have the highest risk of failure because of their heavy commercial real estate (CRE) concentrations.

The FDIC’s stress test is substantively similar to the Federal Reserve’s stress test for the major US banks, published on 22 November 2011. In that proposal, the Fed outlined a gloomy stress scenario, characterized by a deep US recession beginning in fourth-quarter 2011, with four consecutive quarters of negative GDP growth, unemployment rates reaching 13% by early 2013, and home prices falling another 20% by early 2014.
The stress tests will help the FDIC determine whether individual banks have sufficient capital levels to withstand a dire economic scenario. The tests are credit positive because they will help protect against premature capital distributions for those banks that perform poorly in the stress scenario, thereby preserving capital for unexpected losses.

The public disclosure of the test results by each bank will support banks’ access to the capital markets. For banks that pass the test, market confidence will improve. For banks that fail the test and may need to raise additional capital, the conservative economic assumptions underlying the stress scenario will help frame the potential impact of a harsh scenario for investors. Although investors may choose not to invest, the transparency of the process will provide them with quality information to make an informed decision. Without this transparency, more investors would stay on the sidelines, hurting banks’ ability to raise capital.

The banks required to undergo formal stress testing per Dodd-Frank hold 80% of the assets in the US banking system. Although this provides good coverage, it ignores those banks that arguably face the greatest risk of failure: the community banks. Since the onset of the global financial crisis, community banks have failed at a rate not seen since the 1990s, and they continue to dominate the FDIC’s problem-bank list. Many of these banks remain weighed down by massive CRE concentrations that include toxic construction and land exposure.
As the exhibit below shows, community banks with less than $10 billion in assets represent 20% of total banking system assets, but almost 50% of CRE loans outstanding. In aggregate, CRE loans represent 254% of Tier 1 capital for this group of banks, compared with 86% for banks with more than $10 billion in assets.

Community Banks Have Large Commercial Real Estate Concentrations as of 30 September 2011