Stress relief 3.0

The Federal Reserve has found the right balance with its latest round of stress tests of the 19 largest US banks. Unlike its last look under the hood of American finance a year ago, the central bank’s regulators this time are giving investors reams of more useful data to help separate the industry’s sheep from its goats. And they’re acting prudently to ensure capital adequacy in the system.

The results were better than expected considering the extremity of the stress scenario: banks had to prove they had enough capital to withstand a 13 per cent unemployment rate, a 50 per cent crash in the stock market and a 20 per cent slump in house prices. That led investors to assume that few banks would be allowed to reinstate or boost dividends or buy back stock.

As it happens, 15 of them got clean bills of health, prompting first JPMorgan and then others to announce their plans for putting surplus capital to work — though Bank of America submitted no request to do so and Regions Financial decided to use the Fed’s blessing to sell $900 million of common stock.

What’s more, the four banks that failed shouldn’t be cause for alarm. While Citigroup flunked, it only did so by a whisker. Citi’s hardly in bad shape and boss Vikram Pandit still has a few irons in the fire— allowing Morgan Stanley to buy all the bank’s stake in their wealth management joint venture sooner than anticipated would, for instance, free up $10 billion of capital instantly, subject to Fed approval.

The laggards — including Ally Financial, insurer MetLife and SunTrust — may not like the results. But by forcing these banks to further retain earnings and capital, at a time when the economy and markets are relatively stable, the Fed is following through on its enhanced mandate as a macro-prudential regulator under the Dodd-Frank Act.

Bank shareholders shouldn’t get too cocky, though. The tests may prove that bank balance sheets are relatively robust. But most institutions are failing to earn their cost of capital — meaning that even JPMorgan and Goldman Sachs are struggling to trade above book value. That’s not the Fed’s concern, of course. It wants to keep the next financial crisis at bay. This level of transparency helps ensure that outcome.