One of the comforts with which bank regulators will doubtless console themselves after last week’s market rout is that the largest U.S. banks have the capital not only to withstand this, but also the probable, profound consequences of the President’s punitive tariffs. However, because U.S. regulators mismeasure capital resilience, this confidence is misplaced. Using the economic-capital approach I recently endorsed shows that, while U.S. banks still are strong, they are not fortresses.
FedFin recently analyzed two new studies demonstrating that geopolitical risk is hard on bank solvency. To this, one of course can say that there’s no real-world need for exhaustive studies of dozens of countries over decades – common sense buttressed by history makes this all too clear. These hard lessons and the data that describe them do, though, make clear that it’s more than worth revisiting the United States after the Smoot-Hawley tariffs to get a sobering idea of the negative feedback loop between geopolitical risk, macroeconomic hazards, bank vulnerability, and – back to the beginning, geopolitical risk. Any talk of the 1930s is alarmist and also inapplicable in numerous respects, but it is the most pertinent example of geopolitical risk over the past century and thus demonstrates the need now to be very, very careful – not something this White House appears to be good at.
Economic-capital measures are a more robust platform to assess bank resilience than regulatory capital and are thus of particular pertinence at this dangerous moment. Regulatory-capital measurements are so complex and often prove internally contradictory even before one tries to integrate capital resilience with liquidity strength. The liquidity rules are also complex constructs based at least as much on regulatory imagining as on actual circumstance, with none of these abstruse requirements deigning to consult the market for its opinion on franchise value and thus resilience both under stress and over time. No matter how much regulators like banks, banks cease to be viable enterprises if markets do not second this emotion.
As developed by Federal Reserve Bank of New York staff, economic-capital is calculated by netting the net present value of financeable assets versus par liabilities as a baseline measure which can then be tested under various stress scenarios that start with illiquidity that end in insolvency and vice versa. This leads to a robust measure of survivability that combines the impact of credit risk, possible illiquidity, and the real-world market conditions current rules ignore even though these are the criteria by which investors and counterparties bless or damn a bank. Very, very importantly, investors and counterparties take these data and use their own models then to project forward-looking resilience. The entire corpus of costly, cumbersome bank regulation looks in the rear-view mirror.
One might say this isn’t a fair assessment when it comes to Fed stress-testing, but I think it is because the regulatory measures against which stress is judged are essentially academic constructs that take no account of countervailing forces such as liquidity stress. This is measured by separate tests and never the twain meet even though, as each financial crisis reminds us, capital and liquidity are inextricably intertwined. Now would be a very, very good time to assess the largest banks around the world in terms of their economic capital – as last week showed all too clearly, investors and counterparties are already making judgments and few are flattering.
Regulators remain confident, but the double-sided stress to which President Trump’s tariffs have plunged the global financial system – see our report last week – add sovereign and geopolitical risk to a nasty brew of credit, market, and capitalization strains. I doubt and devoutly hope the globe is not facing another systemic crisis, but trusting misleading data only makes matters worse.
Markets are ruthless and swift and yet supervisors seem always to be caught by surprise. The only go-to they know when regulatory measures fail is forbearance when markets allow it and bailout when they don’t. Moral hazard raises the social cost of financial stress even as moral hazard becomes still more embedded. Economic capital is not the only answer to rear-view regulation and complacent supervision, but it’s a start.