There have been cries of complaint since the Fed very notably failed Citigroup's (NYSE:C) capital plan for the second time in recent memory, with predictably negative results for the company's stock price. Bank of America (NYSE:BAC), on the other hand, sailed through the process, despite an initial bout of worry about its low leverage ratio.
In the aftermath, critics have lamented the Fed's "black box" methodology, its irresistibly rising standards, and its alleged game of "gotcha" with unsuspecting executives.
I doubt Chair Yellen is purposefully messing with anyone, though I admit this would amuse me. I also give credit to the Fed for making it harder for banks to adhere to the letter of the law at the expense of its spirit -- at least when it comes to their capital plans, which are measured on both quantitative and qualitative factors.
And yet, despite its attempts to affect a stern regulatory role, the Fed's tests are simply too easy. Here's why Bank of America should be thanking its lucky stars.
1. Capital Ratio Requirements Are Too Low
The minimum Common Equity Tier 1 ratio for the stress test is 5%, with the required ratio ticking higher for globally significant banks. Remember that this is 5% of risk-weighted-assets, not total assets, which means it involves a lot of assumptions of how risky things actually are.
Bank of America's Common Equity Tier 1 ratio result was 5.9%, the lowest of the major banks and the second lowest overall after Zions Bancorp, which had a ratio of 3.6% and failed the test outright. Bank of America's capital plan was approved, however, after some hasty revisions. Citigroup's ratio was 7.2%, comfortably above the minimum, and yet it failed the capital plan on "qualitative" grounds.
Not only is Bank of America's ratio quite low, especially for such a prominent bank, the bar itself is hardly intimidating. Remember, we're not only dealing with highly levered, globally significant financial institutions, we're also not fully accounting for their "riskless" or "low-risk" assets (I put them in quotes because these kinds of claims belong in quotes).
So what should the ratio be? Sir John Vickers, who led banking reforms in the UK, has said that it should really be more like 20%. Quite a difference there.
2. Leverage Ratios Are Too Low
Related to the above, the minimum Tier 1 leverage ratio must be greater than 4% for tested banks. In other words, total Tier 1 capital only needs to be 4% of total exposures. This is a tougher test, obviously, as it doesn't allow risk-weighting, but it's still low. The editors of Bloomberg View drily noted that banks "should not be allowed to get anywhere near such a level"
Bank of America had a leverage ratio of 3.9% in the tests (if you're wondering why it passed even though this is definitely below the requirement, it's because the company's revised capital plan apparently met the Fed's qualitative and quantitative standards). Okay, you're thinking, good for them. But when you think about what this number actually means, you come to realize that the policy is frighteningly undemanding.
If the value of Bank of America's total exposures drops 3.9%, it's out of easily accessible capital. This doesn't seem so far-fetched after 2008. What happens next? We know this story: If the bank wants to generate more capital to avoid insolvency, its executives would have to sell something. But if there's a crisis, valuations are probably also going down, so selling assets at reasonable prices might not be so easy.
Unless we turn to the Fed?
3. Moral Hazard: Yup, Still There
The Fed has tried to show that it can be tough on banks and that it won't provide for the future bailouts of failed institutions, but these claims don't really have any teeth.
Low standards for banks are a problem for everyone but the banks. Why? Ask yourself this: if a real-life crisis blows through the minimal capital that the banks -- or in this case, Bank of America -- obediently accumulated, who's going to be left holding the shortest stick?
In this situation, I don't think the Fed will be able to turn around and blame the financial sector for its failures; on the contrary, it would give banks like Bank of America better grounds than ever for a government bailout. After all, it passed all the tests -- it's not the bank's fault the tests were too easy.
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Anna Wroblewska has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America and Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.