Well, we’re impressed.  Even though the regulators’ stress test was designed to ensure no
one can fail it, the measurement is in fact far more disciplined than many — ourselves
included — anticipated.  Perhaps because criticism mounted, regulators tightened up the
test even as it was administered.  Parsing the details of the new methodology, we
conclude that it will be very, very difficult for any big bank to get out of TARP.  The best
most can hope for is to stay as they are and not be forced to draw down still more TARP
capital or convert what they’ve got into common stock.   
 
The supervisors took a hard line on any number of aspects of the stress test.  For starters,
they didn’t bow to the FASB mark-to-market rewrite earlier this month.  They have let
banks resubmit stress-test conditions under the baseline scenario based on any
accounting-derived improvements, but they won’t rewrite the adverse-scenario test no
matter how prettied up mark-to-market makes it look.   
 
The regulators have also taken another tough stand on a critical, if less noticed,
accounting issue:  consolidation.  A major FASB rule in the works would require banks
to bring back on to their balance sheets huge amounts of obligations housed in fancy
structured investment vehicles and similar off-balance sheet boxes.  The scope of this rule
is clear – the regulators calculate that a revised FAS 140 would bring $900 billion in total
assets and $700 billion in risk-adjusted ones back on to balance sheets.  If banks can
sustain this along with the tougher marks under the adverse scenario, they’re more than
resilient, in our view.
 
Stress-test foes have also argued that the results won’t mean much because regulators
will judge capital adequacy based on regulatory capital, not tangible common equity
(TCE).  We’re no fan of TCE, as previously noted, although we strongly agree with
longstanding regulatory policy that the greatest amount possible of regulatory capital
should be common equity.  It doesn’t, though, need to be all of it because a simple TCE
measure based on GAAP misses a lot.
 
For starters, it misses risk.  The risk-based capital rules, for all their flaws, do this and
that’s a far better way to look at a bank than a simple, unadjusted number.  But, one of
the long-recognized flaws in the regulatory model is its failure to catch default risk
embedded in trading books.  Regulators proposed doing this a few years ago and then
bowed to industry opposition – oops.  Now, they’ve got a rewrite in the works to include
an incremental-default charge in market risk-based capital measures.  Not waiting for the
formal rule change, though, the stress test includes an incremental-default charge.  This
will put the five big banks with trading books of more than $100 billion under a new
capital gun – and a good thing too in light of all the previously-unrecognized
counterparty risk buried in the trading book.  If these big boys do well even with this new
charge, they’re in remarkably good shape.
 
Our guess is, though, that the five biggest banks won’t pass the incremental-default test
with flying colors.  In fact, given how tough the test is, most banks will have difficulty
swinging through the adverse scenario on current capital and loan-loss reserves.  This
will lead most – if not all – of the nineteen biggest banks right back to where they started:  
TARP capital.  Few, if any, of the biggest banks will do so well under the stress test that
they could plausibly defend returning TARP capital even if Treasury felt that doing so
wouldn’t be harmful to broader economic recovery.   
 
And, if the strongest banks are stuck in TARP, what of the weaker ones?  One small point
in the methodology bodes ill for them.  In addition to all the tough requirements noted
above, the standards take a hard line on merger discounting.  The regulators don’t buy
bank assertions that these discounts are as bad as things will get; instead, they stress test
these assets to determine if discounts are deep enough.  For banks – BofA anyone – that
just bought a lot of bad stuff, this requirement will be a very high barrier to getting out of
TARP.  Any bank that’s been in the merger game of late almost surely will not only stay
stuck in TARP, but also need more capital through new draws on TARP and/or preferred
conversions to common equity..