Kroll's Whalen Sees Fed's Bank Stress Tests as Miguided (Audio)

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Charlie Pellett and that's Subloomberg Business Flash. You're listening to taking Stock with Pim Box and Kathleen Hayes on Bloomberg Radio. It's past failed. But the feder Reserves stress test either you have enough capital with standished severe economic shock or you don't. That's why we're gonna dive now into the results on the latest dress test just announced by the Federal Reserve with a man who is known for his top down and bottom up look at big banks, their

balance sheets and more. Chris Wayland, senior Managing director at the Kroll Bond Rating Agency here in New York City, joins us. Now, Chris, welcome back, Good afternoon, Kathleen. So everybody passed, though Morgan Stanley trailed the rest of Wall Street in a key measure of leverage. What do you see in these results? Well, it's hard to say that FED doesn't give us enough information to really assess the tests in a, you know, in an objective sort of way.

It's good that they all passed because of the obvious cost. You know, if you fail, you're not allowed to return money to shareholders, You're not allowed to pay the dividends you want. So it has a big impact on the equity markets. UM. And really, as we've discussed in the past, Kathleen, you know, bank stress is not about capital. It's about liquidity. That's why we had the crisis, and so these tests are kind of to make us all feel good. But

does a bank ever consume capital before it fails. No, So the whole premise of the test is I think a bit misguided. And it goes back to you know, Secretary A. Geitner when he first came up with the idea of stress tests as a way of restoring confidence in banks, UM, it had an obvious political uh utility. But the continuing stress tests that we go through each year,

you know, frankly or enormous drain on banks. The senior management has to spend months modeling economic scenarios and a lot of stuff that has nothing to do with running the bank. Uh. And so when you look at these results, you really don't know what to say because the FED

doesn't give us enough information to understand the tests. And in particular, you know, true question about Morgan Stanley to understand just why it is that they did less well than the others, you know, since they all passed, right, Chris Whalen has the Federal Reserve in following the Dodd Frank legislation, Have they created this whole other industry within banks that has nothing to do with the banking industry, where the functions that they provide to their customers or

their clients. Well, it's certainly a big cost. I mean, it is a lot of additional cost for banks which comes out of the pockets of shareholders. And yes, I agree with the way you characterize. It really has nothing to do with running the bank. I often asked the banks that we rate, who's running the bank while you work on the stress test, because it's just it's board members, senior management and lots of consultants. Well, a way is

a heart. I'm looking at our Bloomberg's story by Jesse Hamilton's and Dacan Campbell, and it looks at systemically important bank. So that's well as far will be of a JP Morgan, Goldman, Morgan, Stanley, City State and Bank of New York melot and the regulatory minimum, for example, for a common equity Tier one capital ratio is four and a half percent, and then it shows what the capital ratios are. Wouldn't be pretty easy if you're a big bank to say, oh, here's

my capital ratio. Boom if I'm above four and a half percent, am okay, right. But you and I could do a very thorough stress test, Kathleen with the public data in half an hour. We wouldn't need to come up with economic scenarios. We wouldn't have to employ economists and other consultants to work on this for months. Stress

testing is about loss absorption. That's all it is. But you know, if you think about it, when a bank fails, the only thing that capital really does is offset losses to the industry, because the industry ultimately backs up one another, joint in severally. That's what the fdi C is. It's a big mutual insurance company and the industry stands behind it. So only if a bank fails do we care about capital.

What really matters if the bank is a going concern is liquidity and access to markets and confidence with a capital C that's all it matters. If you don't have confidence, no amount of capital will save you. Chris is part of this confidence building exercise. I understand that banks had to project greater losses than in previous stress tests, including what about a hundred and thirteen billion dollars in trading losses for that that was for the eight largest firms, right, Yes,

how did they come up with that number? They're doing is they're trying to throw a severe scenario at the bank and say could you get through such a scenario and still have capital left? Um, we do very similar sorts of tests on banks when we rate them. We look at a moderate scenario and then we look at the crisis and say, how did you do through the crisis? Because that was a big spike in losses. It was

enormous for three s four standard deviations. So you know, it's all fine, but it doesn't really tell me as an analyst whether or not a given bank is going to be able to do well in a time when investors get cold feet and run, which is what happened in in in two thousand and eight. And again remember,

but it's all about liquidity, it's not about capital. Uh. And with all due respect to my colleagues in the FED and everywhere else, um, you know, capital has become the panacea it's the thing we all grab onto and say, oh good, the banks are safer, But really, market liquidity

hasn't recovered. And I think what the FED is doing here, PIM is they're kind of talking their book because with monetary policy, we've distorted markets, We've distorted credit spreads, and I think the FED is a little worried that once we start to see rates go up, you're going to see a lot more volatility. Well, now the Feds talking it's books, but the stress tests are the outcome of the Dodd Frank regulation passed by Congress pick Kathleen the focus.

You know, PIM was just talking about trading losses, big concern. I'm much more worried about a lack of revenue for banks from trading. Frankly, yeah, you know, and I get that. I mean, there's a lot of still a lot of controversy over the vocal rule and everything. But it seems to me that the you know, the FED is sort of just going along with what Congress wanted to see, which was something, uh, something more really hitting at the banks.

And anytime you turn on the news, Boomberg Radio, Bloomberg television, any Bloomberg outlets read the stories. Someone in Congress is saying, well, well, one of two things. Some are saying you're not strict enough, and that's gonna be a big issue in the campaign. The presidential campaign of thos are saying you're too tough. Well, look, you know, the good news is American banks are very well capitalized compared to banks around the world. Do they

have enough capital? It's hard to say, But what I can tell you is that the approach of regulators is basically to punish the victims, particularly the shareholders, and hope that by punishing the victims, they're going to change the behavior of the banks. But we're not punishing the people who caused the crisis. We've already said we won't do that. So it's a very strange approach. You know, you punish everyone but the guilty, and you hope that the innocent

they're going to prevent them for being bad in the future. Okay, that's that's a very indirect way of approaching the problem. Right. Well, here's something perhaps even more indirect, if that's possible. Next week, the Federal Reserve will announce the institutions that asked or failed the qualitative part of their exams and haven't the banks complained that the qualitative portion tends to be subjective?

Is it subjective? You're you're assessing management, you're assessing internal systems, You're you're trying to discern whether they have good risk management, does management know what risks they're taking? These are qualitative issues, and they're very similar to what we look at in the ratings world. We have the quantitative stuff, the numbers, and the qualitative parts of the most difficult to judge because you're ultimately looking to see whether or not the organization,

the people, the systems can prevent risks. And that's that's the tough part. Well, then, uh, let's step back big picture, depending on whoen's the White House and the congressional races. Um, any chance someone would say, you know what, this is just too much work. Why don't we just make it clear to banks that if they don't have enough capital and they don't really listen to their risk management officers and they get in trouble, we are just going to

quickly resolve them and do it that way. Would that put the fear of you know, financial regulator, that you know, the fear of the market into them, and you would need all this stuff, well, I suppose I think a better way, Kathleen would be to force in the raise more capital, and that's what we're doing now. Do away with the stress test and simply rely on public data

the investors can look at and understand. And then I think put a lot more emphasis on confidence, on avoiding fraud, on avoiding types of events and missteps that cause investors to lose confidence. Because when investors run away from a bank, when they no longer will face a Lehman or a Bear or whomever, right that that that institution can't function, doesn't matter how much capital they have. It really doesn't. At the end of the day, they have to have

access to the market, so it's about liquidity. Thank you very much for joining us. Chris Whalen is senior managing director at the prole Bond Rating Agency and the polls are closing in the UK in just a few minutes and we will be covering it next. You're listening to Bloomberg Radio