Why U.S. Bankers Can't Sleep at Night

The Australian Financial Review, November 26, 2011

Anna Bernasek New York

What a difference a month makes. When US banks released third- quarter earnings in October, sentiment was riding high. In stark contrast to their European counterparts, US banks had recovered from the 2008 financial crisis and were poised to gain momentum. But now a looming euro debacle is fuelling fears that again America’s financial institutions are vulnerable.

With the sharemarket under heavy selling pressure this week, financials were singled out for punishment. The mood has soured since November 16 when Fitch Ratings warned it might reduce its “stable” rating for major US trading banks. “Unless the euro zone debt crisis is resolved in a timely and orderly manner, the broad outlook for US banks will darken,” Fitch said. “The risks of a negative shock are rising.”

By most reported measures though, US banks are in far better shape today than leading up to the 2008 financial crisis.

Start with capital levels. From the end of 2008 to 2010, common equity increased by more than $US300 billion at the 19 largest US bank holding companies, the Federal Reserve says. Capital levels increased further in 2011 and by the third quarter were at their highest level since 1938. Timothy Geithner, the Secretary of Treasury, says most US banks have reached the new minimum capital standards set out by the Basel III international agreement.

In addition to substantial capital, banks have considerable liquidity as economic softness kept US banks from ratcheting up risk. For the first time, US banks have fewer loans on their books than deposits. Meanwhile, plentiful cheap money has kept profits healthy. The Federal Deposit Insurance Corp reported this week that the industry earned $35.3 billion during the third quarter, up $11.5 billion from a year ago. That puts US bank earnings at their highest level since the second quarter of 2007.

In another sign of health, legacy issues from 2008 have shrunk. The number of problem banks on FDIC’s watch-list declined again in the third quarter to 844. The majority of the troubled banks are small, having combined assets amounting to under 3 per cent of total industry assets.

The rules of the road have tightened. The Federal Reserve’s annual stress test got underway this week. That process will culminate with a pass or fail verdict handed down to major banks early next year. The test is tougher than last year’s to take into account the European crisis.

Banks have been asked to prepare for a “doomsday” scenario of 12 per cent jobless next year, an 8 per cent drop in GDP and home prices down another 20 per cent.

While the European crisis seems threatening, it may also turn out to be an opportunity. As French banks in particular disappear from large syndicated loan deals, US banks are there to step in.

Perhaps the biggest threat is the one that keeps bankers up at night. “Ask any US bank of significance today and you’d find they’re not worried about direct exposure to Europe,” says Tom McGuire, head of the capital advisory group at Barclays Capital in New York. “They’re worried about what happens to confidence. No one knows the downside if the European crisis isn’t resolved.”

If business and consumer confidence vanishes, banks will be hit in their weakest area, loan growth. That would bring earnings under pressure, weakening their entire business model. Instead of being poised for growth, banks would be back to shrinkage. Knock-on effects such as weakness in housing and real estate would affect asset quality, potentially reversing the positive trends.

While bankers seem unconcerned about direct exposure outside the US, industry experts believe it is still a big unknown. Fitch’s downgrade was based on the industry’s exposure to potential losses arising in Europe. Up to now only a handful of banks have released any details. These include Bank of America, which said its exposure to Greece, Ireland, Portugal and Spain totalled $US14.6 billion, while Citibank said its exposure was $US20.6 billion and JP Morgan $US15 billion.

But the amounts do not clarify all the issues. In its report, Fitch criticised the banks for not airing the extent of their holdings of European sovereign debt or their trading positions with European counterparties.

In addition, if the crisis spreads, US banks will find it difficult to avoid. The Congressional Research Service estimates that while the exposure of US banks to Greece, Ireland, Portugal and Spain amounted to $US641 billion, their exposure to German and French banks comes to more than $US1.2 trillion. Combined, that makes up something like 15 per cent of total US commercial banking assets.

As Europe lurches along, counterparty risk could become a big threat. Still an opaque subject, the vast interconnectedness of modern banking nearly brought the global financial industry to its knees during the 2008 crisis.

And no one really knows how big a problem counterparty risk is until it’s too late. After all who can forget Lehman Brothers. On the day of its bankruptcy, Lehman held an investment-grade credit rating.