Everyone’s talking about the most recent Federal Reserve stress tests. Not because anyone failed, but because all of Wall Street’s biggest, baddest banks scored really low.We’re talking about banks with trading floors — JP Morgan, Bank of America, Morgan Stanley and Goldman Sachs.
And here’s what “scoring low” means. The stress tests are supposed to determine how much equity Wall Street banks would have in the event of another severe financial crisis.
The metric everyone is paying attention to is the Tier 1 Common Capital ratio. That’s the ratio between everything a company owns (with liabilities subtracted) and a firm’s risk weighted assets (all of a firm’s assets that weighted for credit risk).
The point is, it’s supposed to indicate how much a firm would be worth if everything goes terribly wrong.
Photo: The Federal Reserve
The Fed set the minimum ratio at 5%. The biggest Wall Street banks came in just above that.Via WSJ:
- 5.7% at Morgan Stanley,
- 5.8% at Goldman Sachs,
- 6.3% at J.P. Morgan and
- 6.8% at Bank of America Corp.
According to the test, Goldman alone would lose $20 billion in a doomsday scenario. Goldman, for its part, says that the Fed’s calculation is flawed and that it would actually hold 8.6% of Tier 1 Common Capital.
The only financial institution that scored lower than these banks was Ally Financial, which is going through a big bankruptcy proceeding to get rid of its mortgage unit. The bank with the highest ratio, by the way, was Bank of NY Mellon with a 13.2% ratio.
What all the other low scoring banks above have in common, of course, is that they have big trading operations. That means more credit risk.
This falls in line exactly with what analysts have been saying about banks. Take Meredith Whitney, for instance, she has always pointed out that banks that hold too much capital are sluggish, bad businesses.
Her recommendation, though, was to hold less capital and make money from less risky, less fancy, high fee businesses like asset management.
It looks like Wall Street agrees about capital = sluggish part. They’re holding enough to get by, still pass the test, and keep their trading operations going.
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