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The worst may be over for US banks

Published: 05:30 14 May 2009 AEST

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The major news event of the last week for global equity markets was the outcome of the Fed’s stress testing of key US banks. The concept being that the banks should model their projected capital requirements under a range of potential loan-loss scenarios. The banks then have to raise any additional capital that the testing concludes they might need.

The additional capital would preferably come from private investors. Although, given that the Fed had pointedly stated that they would not allow any bank participating in the tests to fail, public funding is also available.

As we have discussed at length in the past, confidence is a critical factor in facilitating a healthy market and banking system in particular. By providing clarity as to the extent of the banks’ potential capital requirements, and ensuring they have access to that capital, the Fed hopes to rebuild confidence.

The Fed announced the stress testing quite some time ago, and some had thought the results would prove the catalyst for the market’s next downward dynamic. In the event, the results were nowhere near the doomsayer’s dire predictions. Of the 19 banks that participated in the testing, 9 did not need any additional capital and the requirement for the remaining 10 totalled $75 billion.

The market rally into and following the announcement was therefore likely supported by short covering as the bears closed out their positions.

Since the release of the data, however, there have been suggestions that the testing process was not quite as rigorous as one might have expected. A report in the Wall Street Journal alleged that the banks managed to argue for a reduction in their capital requirement by including pending transactions in their calculations. Had this not been the case, then the banks’ overall requirement would have been significantly higher.

Further criticism is levelled at the definition of capital used by the tests. Rather than tangible common equity, the Fed chose to use the less easily understood tier 1 capital measure. Meanwhile, other critics suggest that the “worst-case” scenarios were not severe enough and that the banks’ loan-losses could potentially be greater than the testing envisages.

Really though, there is little chance that the stress testing process would ever have achieved universal appeal. One could debate the test’s parameters ad infinitum. As we have discussed in the past, our view remains that the unprecedented actions of the world’s central banks and governments has prevented a 1930s style meltdown.

The banks will continue to incur loan losses as the recessionary cycle plays through, albeit to a greater degree in the US and UK. However, there is very little probability in our view that the US banking system will incur deeper damage than the testing presumes. Once the re-capitalisation process is complete, we will certainly not have a repeat of the days of horror that followed the Lehman failure, which saw the global banking system teeter on the brink of collapse.    

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