People metaphorically use the phrase “throwing the baby out with the bath water” as a warning about unintended consequences. According to internet lore, the idiom came from the practice of large families washing in the same water, and the smallest child could inadvertently be tossed. Regardless of the expression’s veracity, seemingly great ideas have a way of surprising us.
Recently, the Treasury Department proposed reducing the leverage ratio, a measure of financial strength based on assets and loans banks must maintain to assure capital adequacy. Banks in the United States must maintain a 5 percent leverage ratio to avoid bonus and dividend restrictions. European banks though have much lower ratios, 3 percent. On the opposite side of the debate, Thomas Hoenig, head of the Federal Deposit Insurance Corporation, argues the leverage requirements should be much higher. Hoenig reminds us the amount of money banks lost during the financial crisis was 6 percent. Bottom line, higher leverage ratios reduce the likelihood of another taxpayer bailout.
Federal Reserve chair and Obama appointee Janet Yellen lent credence to the Treasury Department’s argument when she touted the banks successfully passing “stress tests,” a measure of how adverse financial conditions affect banks. “I think the public can see the capital positions of the major banks are much stronger this year,” Yellin noted.
Recently though, Spain’s fifth largest bank, Banco Popular, went belly-up despite successfully passing similar stress tests. Large bank failures generally spook financial markets, but this time, meh. Investors, though, should look at stress tests like I look at water quality tests. Both of them are snapshots that measure one point in time and future events can change results dramatically.
Proponents of lower capital requirements contend tight restrictions impede growth, but the overwhelming evidence shows lax lending practices exacerbated the 2007-2009 financial crisis. Sure, getting a loan is more difficult now; back in the day, banks loaned to anyone who could fog a mirror. Relaxing capital requirements may spur economic growth, certainly in the short term, but the problem with loans is not capital availability but demand. With middle class Americans financially pinched, loan demand will continue to suffer.
Yellin’s comments gave me some confidence since she found the banking sector “much safer and much sounder” than in 2008. She also warned against more permissive monetary and regulatory policies for the financial industry. With an appropriate system of supervision, she predicted a repeat of 2008 would be unlikely “in our lifetime”.
Relaxing leverage ratios and other capital requirements will make banks more profitable and boost the S&P 500. However, banks will be hard-pressed to weather a dire economic storm, like a double whammy of high unemployment and real estate market turbulence. A positive stress test today may turn out to be mirage tomorrow.
You can’t always get what you want, but Buz Livingston, CFP can help figure out what you need. For specific recommendations, visit livingstonfinancial.net or come by the office in Redfish Village, 2050 Scenic 30A, M-1 Suite 230.