On May 7th the U.S. government will reveal the results of the stress tests that they put the country’s nineteen largest banks through to see if they could withstand further economic deterioration. The worst case scenario could include several bank failures which may sink growing optimism and spark dollar support on increased risk aversion.
On May 7th the U.S. government will reveal the results of the stress tests that they put the country’s nineteen largest banks through to see if they could withstand further economic deterioration. The worst case scenario could include several bank failures which may sink growing optimism and spark dollar support on increased risk aversion. We have had divergent preliminary reports over the past few weeks including an early report that stated that no banks had failed. On April 24th banks received the results ahead of the public and since then there has been speculation that anywhere from one to as many as ten banks will need to raise more capital. Several of the nineteen evaluated including Wells Fargo have already disputed the claims saying that it is strongly capitalized. The Federal Reserve said its tests were aimed at ensuring adequate capital was in reserve so that major banks could continue to lend in potentially bleaker conditions, and not a measure of banks’ solvency. They released their methodology for the tests which included two scenarios a baseline and a severe and asks banks to determine their capital needs under each. The scenarios included estimates for GDP, unemployment and house prices or 2009 and 2010.
Considering the speculation there is no telling what we may expect from the bank stress test results but it appears that it may be one of three outcomes. The most pessimistic scenario would be that several banks are required to secure immediate funding without government aide. The Obama administration is reluctant to go back to Congress for more funds and may leave the responsibility to the financial institutions to meet their liquidity needs. The troubled banks may not only have the inability to raise the needed capital but could be in jeopardy of failing as their fragility could discourage new business. Yesterday, Fed Chairman Ben Bernanke stated “A relapse in financial conditions would be a significant drag on economic activity and could cause the incipient recovery to stall.” Therefore, if we see some of the larger banks fail it could have a ripple effect throughout the banking system and could undo the efforts of the central bank to provide liquidity. Investors may fear the worse sparking risk aversion and reverse the recent rally in equities driving safe haven flows back into the dollar and yen. The recent beneficiary’s of the increase in optimism like the pound, Australian and New Zealand dollars could lose support.
The most optimistic scenario is that the majority of the banks proved worthy of the challenges ahead and the remaining have limited capital needs which can be meet by the government with the remaining TARP funds. In this case we could see a sharp rise in risk appetite as the U.S. economy has already started to show green shoots of growth including improvements in the ISM manufacturing and service gauges and the less than expected number of job losses in the ADP private employment report. The increase in optimism could add to recent dollar and yen weakness and send the Euro, pound and other currencies positively correlated to risk appetite higher.
Recent reports that Bank of America will need to raise $34 billion in capital makes the rosier outlook unlikely. However, there is a growing confidence that the troubled bank will be able to raise the funds by converting the preferred shares that they sold the government into common or exploring selling assets like their stake in Blackrock. Other beleaguered banks will have similar options which could make the results a non-event. Especially, if market participants believe that another crisis is unlikely but that more work needs to be done to completely eliminate the threat. Additionally, the results themselves may potentially not deliver the expected impact as the government may sugar coat the results in order to avoid panic and put the banks in greater peril. The public spotlight that is on the outcome may lead regulators to not release enough details for traders to form their own conclusions. In this scenario it could leave a cloud over markets and investors directionless. However, this environment could lend dollar support as cautious traders may favor the safety of U.S. Treasuries to riskier assets despite the improving economy.