Banks passed the stress test. Now comes the real test

All twenty-three banks in the Federal Reserve's annual stress test passed in late June, showing on paper that they could survive a severe fall in commercial property prices and a global recession. Bank shares rallied and boards prepared to pay out billions in dividends and buybacks. The exercise has become a regulatory set-piece. Passing a hypothetical exam says little about the problems banks actually face.

What the exam assumed

This year's severe scenario imagined unemployment climbing to 10 per cent, house prices falling by more than a third and commercial property values dropping by around 40 per cent. Under those conditions the banks would collectively lose more than half a trillion dollars and still hold capital above their minimum requirements. Within days, several of the largest lenders announced higher dividends. On its own terms the result is reassuring, and the Fed has good reason to publish it.

The scenario also had interest rates falling, as they usually do in a recession. That is a reasonable assumption for a downturn, but it means the test did not model the danger that actually brought down Silicon Valley Bank, Signature Bank and First Republic this spring. Those banks failed because rising rates cut the value of their bond holdings while depositors fled. The Fed ran a separate exploratory exercise on trading shocks this year, but the headline test that governs payouts was built around a different kind of crisis.

Basel rules and fleeing deposits

The bigger worry is the coming 'Basel III Endgame' revisions, which could inflate risk-weighted assets in trading and corporate lending. Regional lenders, meanwhile, keep losing cheap deposits to money market funds that pay more, and their net interest margins are shrinking as a result. The Fed's exams measure capital against imagined crises. They offer no protection against the slow erosion of profits on funding.

The capital bill arrives

The Endgame package is the final instalment of the Basel III reforms agreed internationally after 2008. American regulators are expected to publish their version shortly, and Michael Barr, the Fed's vice chair for supervision, has made clear since the spring failures that he favours tougher requirements for more banks. The main effect is on how banks measure risk rather than on the headline ratios. Changes to the treatment of trading books, operational risk and some corporate loans would push up risk-weighted assets, so the same pile of capital covers less business.

For shareholders that is a direct trade-off. A bank that must hold more capital against the same balance sheet can either shrink its lending and trading, raise prices to customers, or retain more earnings. The last option is the easiest, and it comes out of the buybacks that boards were so keen to announce after the stress test. The dividend increases are therefore less secure than they look, since the rules that will govern them over the next few years have not yet been written.

Deposits find a better home

The funding problem is older and simpler. For most of the past decade banks paid close to nothing on deposits because savers had nowhere better to go. With the Fed's policy rate above 5 per cent, money market funds now pass on much of that yield, and their assets have swelled past $5trn. Every dollar that moves from a current account paying almost nothing to a fund paying 5 per cent is a dollar the bank must replace with costlier funding.

Banks can keep deposits by paying more for them, but that compresses the margin between what they earn on loans and securities and what they pay for money. Much of their asset book was locked in when rates were low, in the form of mortgages and long-dated Treasuries that will not reprice for years. Funding costs adjust in months; asset yields adjust over years. The Fed's Bank Term Funding Program, set up in March, lets lenders borrow against their bonds at face value, which has stopped the runs but at a rate well above what depositors used to cost.

An old pattern

This has happened before. In the late 1970s regulation capped what banks and thrifts could pay on deposits, and savers moved their money into the new money market funds, which paid market rates. The savings and loan industry, funded by short-term deposits and holding long-term fixed-rate mortgages, was squeezed between rising funding costs and stagnant asset income. The eventual collapse of hundreds of thrifts in the 1980s cost American taxpayers dearly. Today's banks are far better capitalised, but the mismatch between short funding and long assets is the same basic weakness.

Winners and the counter-case

The winners are money fund managers and the largest banks, which gained deposits during the spring panic as savers sought safety in size. The losers are shareholders in regional banks and the borrowers who depend on them, since regional lenders are a large source of credit for commercial property and small businesses. A bank facing higher funding costs and tougher capital rules will lend less, and the firms it serves have fewer alternatives than big corporate borrowers with access to bond markets.

The best counterargument is that the worst is over. Deposit outflows have slowed since May, loan books are repricing upward over time, and bank earnings remain comfortably positive. That is true, and it rules out a crisis. It does not rule out a long period of lower profitability, and a squeeze on margins can do its damage without a single bank failing.

The evidence to watch is in the second-quarter earnings due from mid-July, the Fed's weekly figures on bank deposits, borrowing under the emergency facility, and the Endgame proposal itself. The stress test makes a comforting headline, but it will not stop depositors moving to money funds, and bank margins look set to keep shrinking for the rest of the year. Regional lenders will feel it first and hardest, and the large banks may find by the end of the year that their buyback plans were drawn up for a lighter capital regime than the one on its way.