Last week’s stress test results detailed the continued balance sheet strengthening where 17 of 18 banks passed. The only bank that didn’t was Ally bank. As long-time bulls of the financial sector, there was little surprise in the results. When evaluating the test structures and results, a quote reminded us of the process:
“Experience is a hard teacher because she gives the test first, the lesson afterward.”
-Vernon Law (MLB player of the 1950s & 1960s)
The Fed’s stress test had several parameters; the one startling metric was an unemployment rate of 12.0% and an equity decline of 50% in stock prices and a housing drop of 20%. The Fed has come under scrutiny on these tests because they don’t stress hard enough a more difficult environment than seen in 2008. As an example of why this argument falls flat, consider the highest point of unemployment in the United States hit 10.8% in November 1982.
Some may recall the stress tests conducted by the European Central Bank (ECB) were akin to an open book test where several banks still failed. The banks were instructed to only show trading accounts whereby the investment accounts would be minimized and allowed several subjective positions in sovereign paper be designated as longer-term holdings.
We still see large multiplier impacts to the economy arising from the banking sector over the next few years. The loan to deposit ratio stands at 67%, well below the recent highs but at its long-term average. Secondly, the cash assets held at commercial banks has risen to $1.91 trillion with $948 billion in cash assets held at domestically chartered banks.
Now much of this build up has to do with uncertainty of the regulatory environment. However, as we have noted several times, the regulatory environment and new regulations have become more watered down over the last several years and has seen their implementation deadlines being extended. One note in particular that investors should keep in mind as we continue to see the Basel III regulations evolve, Basel I was supposed to remove the need for Basel II which in itself was supposed to remove the need for Basel III.
The pendulum always swings far to one side during the anomalistic environments as seen in 2008. The stress tests of unemployment (12+% never seen in the last 65 years), equity price declines (similar to the drops in 2001 and 2008) and housing declines of 20% are pricing in what might occur if another 2008 event were to happen. That event was a combination of such rarity it is understandable why some may think a flock of black swans are right around the corner when a black swan is seen. However, history has shown this to be false alarms and a combination of such events occurs maybe once in a generation.
Just as housing will have a multiplier impact on consumer spending, sentiment and employment, so too will banking’s impact on the economy as it continues to slowly expand their cash-rich resources into more profit-generating lending.
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