America is on a Banking Delayed-action Mine

Since 2009, it has been compulsory for all major US banks to pass an exam called a stress test. The test checks the banks’ ability to withstand sudden changes in economic and financial conditions. Put simply, it assesses the banks’ ability to survive should America experience a financial crisis similar to the one in 2007-2009.

In all the years of testing, the majority of US banks have received a rating of ‘satisfactory’, and even then with a stretch of the imagination. Some banks have had to retake the exam. The examiners are financial regulators, first and foremost the US Federal Reserve System, while the examinees are systematically-important banks that are said to be too big to fail. This means that these banks have such a huge number of links and these links are so wide-ranging that their bankruptcy would have catastrophic consequences for the economy as a whole.

Table 1.

Assets of major US banks (as of 15 September 2014)

Banks

Assets, total

JP Morgan Chase

2,527.00

Bank of America

2,123.61

Wells Fargo

1,636.86

Citigroup

1,882.85

Goldman Sachs

868.93

Morgan Stanley

814.51

As Table 1 shows, the total assets of the ‘big six’ US banks as of 30 September 2014 equalled $9.85 trillion. At that point in time, the total assets of the whole banking system equalled $15.35 trillion. In other words, six banks accounted for almost two thirds of all the assets of the US banking system.

Let us also add the assets of the next six banks to the total assets of the ‘big six’ (trillions of dollars): U.S. Bancorp. (0.39); Bank of New York Mellon (0.39); PNC Financial Services Group (0.33); Capital One (0.30); HSBC North America Holdings (0.28); and State Street Corporation (0.27). It works out that the assets of the ‘big twelve’ equal $11.81 trillion, or 76.8 per cent of the total assets of the entire US banking system. The asset figures of banks outside the top 20 are falling sharply. The Synovus Financial Corporation, for example, which is 50th in the list of US banks, has assets equal to $26.5 billion, i.e. almost 100 times less than JP Morgan Chase.

Incidentally, at the beginning of 2014 there were 6,981 banks in the US. It turns out that a vast number of banks are nothing but small fry in comparison with the ‘big six’ and the ‘big twelve’. Every year, the banking giants on Wall Street consistently swallow up small, medium and even relatively large banks. The FRS has monitored the number of banks in America since 1934. At its peak in the mid-1980s, there were more than 18,000 banks in the US. Over the last three decades, more than 11,000 banks have ceased to exist. In 2013, the number of banks fell below 7,000 for the first time, which is less than there were in 1934. The 2007-2009 financial crisis, when most of the banks with assets of less than $100 million exited the market, played its part in purging the US banking sector.

Financial regulators are only interested in the largest US banks. Every year, 20-30 banks undergo stress testing. The main benchmark for getting a positive mark in the exam is sufficient capital. The bank needs to have its own capital and it needs to be liquid capital so that it will be able to cover its obligations (to customers with deposit accounts, other lending banks etc.) in case of emergency. Unlike companies in other sectors of the economy, banks are allowed to work while partially covering its obligations. But the real secret of their resilience lies in the fact that the Central Bank (the creditor of last resort) and the government rush in to save them at critical moments, providing loans to a drowning bank or increasing a bank’s equity capital. According to various estimates, between $1 trillion and $2 trillion of public money was pumped into the US banking system during the 2007-2009 financial crisis. Despite such generous handouts, however, not all the banks were saved. The biggest loss during the crisis was the banking giant Lehman Brothers. On the eve of the financial crisis, incidentally, some of the leading Wall Street banks (Citigroup, Morgan Stanley and others) had a capital adequacy indicator of around 4 per cent.

So how do matters stand with this figure after the crisis? Here are the 2014 stress testing results for the ‘big six’ US banks (%): Wells Fargo – 8.2; Citigroup – 7.2; Goldman Sachs – 6.9; JP Morgan Chase – 6.3; Morgan Stanley – 6.1; and Bank of America – 5.9.

There were no radical changes in 2015 from the year before. The capital adequacy assessment was 6.5 per cent for JP Morgan Chase, 6.3 per cent for Goldman Sachs, 6.2 per cent for Morgan Stanley and so on. Of the major banks that make up the top ten, the Bank of New York Mellon came out top with 12.6 per cent. Experts believe that the value of this indicator across the US banking system as a whole is at the 5 per cent level. This is considered to be the minimum level allowed for banks undergoing testing. In other words, the situation regarding the stability of US banks is far from satisfactory.

Banks are also being tested in Europe, but there are stricter examinee requirements there than in America. In comparison with American financial organisations, some European banks seem like A-star students. Deutsche Bank, for example, has a capital adequacy ratio of 34.7 per cent.

The US Federal Reserve System is not hiding the fact that four of the leading banks on Wall Street only just passed the test in 2015. These are JP Morgan Chase, Morgan Stanley and Citigroup Inc. The banks have been presented with conditions and restrictions in implementing proposed financial and investment plans. The main restriction is in the payment of dividends to shareholders. Problem banks are also being presented with restrictions in buying back their own shares (as you know, this kind of operation is a way of increasing a bank’s market capitalisation).

Citigroup’s top managers are pleased with even a relatively satisfactory mark, since the bank has completely failed the test twice before. This reflected badly on its ranking and market capitalisation, and dividend payments were postponed to a much later date.

This year, two US subsidiaries of European banks – Deutsche Bank AG and Banco Santander SA – took part in the Federal Reserve’s stress tests and both failed. Some experts are referring to these ‘fails’ as a biased assessment, a kind of banking protectionism. European banks like Credit Suisse, Barclays and UBS had said they are were going to put their US subsidiaries forward for the Federal Reserve’s annual exam, but the failure of the European banks in the latest exam has forced them to rethink.

Wall Street banks are currently paying for the lack of control that existed in the US financial sector from the beginning of the 1980s to the 2007-2009 financial crisis. Under Ronald Reagan, a process began to ‘deregulate’ the banking sector. In particular, interest rate restrictions on banks’ deposit operations were lifted. An important milestone was reached in 1999, when the Glass-Steagall Act, one of the first banking laws passed under President Franklin Roosevelt in 1933, was repealed. The law had introduced a strict separation of banking into commercial and investment, allowing the speculation of bankers on financial markets that would risk customers losing their money to be curbed. The final major act in the ‘deregulation’ of banking activities took place under George W. Bush. In 2004, the US Securities and Exchange Commission allowed investment banks to extend unlimited amounts of credit for the purchase of securities (which is exactly what led to the 1929 stock market crash). Banks did not fail to take advantage of this right, having already started to pump up the bubble on the mortgage-backed securities market.

Today, Wall Street banks are stuck between a rock and a hard place. On the one hand, shareholders are demanding generous dividend payments and an increase in the market capitalisation of banks, i.e. share prices, and senior bank managers are unhappy that their bonuses were cut dramatically after the crisis. On the other, financial regulators are trying to curb the greedy aspirations of shareholders and managers. The 2007-2009 financial crisis has still not faded from the minds of Americans, and regulators are giving very specific recommendations. On the results of last year’s stress test, Morgan Stanley was strongly advised to increase its equity capital by $13.66 billion, Goldman Sachs by $9.46 billion, and JP Morgan Chase by $8.38 billion.

The results of the stress testing shows that America is living on a delayed-action mine called the US banking system, and sooner or later this mine is going to explode. According to Simon Johnson, a former chief economist of the IMF, the fact that banks have too little equity capital in conjunction with the sluggishness of financial regulars is creating a serious threat to the US economy. Today, says Simon Johnson, the situation in the American economy is reminiscent of the events that led to the financial crisis: «We already saw this movie, and it ended badly. Next time could be an even worse horror show»