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Coronavirus Crisis Shows That Banks Need To Conduct More Strenuous Stress Tests Now

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When President Trump’s own U.S. treasury secretary states that unemployment could reach 20%, unless legislators finally start implementing some type of fiscal stimulus, what more of a signal do you need to see that the U.S. is in trouble? We have not had 20% unemployment since 1935 during the Great Depression.  Even if Mr. Steven Mnuchin might have used some hyperbole to get legislators to act, and we were to decrease his figure to 15% or even 10%, those unemployment levels are far higher from where we are now, about 3.5%. Even as we are far from determining the true extent of Covid-19 exposures and mortality rate, a number of sources are already estimating that in just a few months we will be at unemployment of almost 7%. 

We do not need official unemployment figures, which are a lagging indicator, to tell us that the official figure will be bad. We are already seeing ominous signs. Every state is already seeing a significant rise in unemployment benefits applications as restaurants, bars, hotels, cultural facilities, and small business such as bakeries and beauty salons close down voluntarily or due to state executive orders. With nationwide hotel occupancy rates plunging from 80% to 10-20%, it should be no surprise that Marriott Hotel announced today that it will furlough tens of thousands of workers.

Moreover, it is important to remember that the typical unemployment metric does not cover people who are discouraged and not looking for work, hence do not count as unemployed, or those who are in the gig economy. Making matters worse presently, in many states unemployed individuals cannot collect unemployment benefits due to requirements to reduce crowds for the sake of public health concerns or because state websites are crashing with lots of people trying to figure out how to claim benefits. Registering for unemployment benefits in New York right now, for example is practically impossible.

With these labor market conditions and the inability for workers to get their unemployment benefits quickly, is imperative that banks start conducting portfolio and enterprise wide stress tests now so that regulators and market participants can see whether banks are sufficiently capitalized to withstand expected late payments and defaults from borrowers. As workers have reduced working hours or are laid off, their ability to service their high levels of debt will worsen. While U.S. household debt to GDP is less than it was in in the run-up to the financial crisis, that information will be of little comfort to bankers when borrowers default on their debt.

Of even more concern to bankers, should be the incredibly high level of corporate debt.  As, I have written extensively in the last couple of years, companies from small to conglomerate have record levels of debt as a percent of Gross Domestic Debt.   As uncertainty continues over the full extent of covid-19 deaths , corporate downgrades, company layoffs and defaults will rise. Particularly vulnerable are companies that are leveraged five times or more than their Earnings Before Interest Tax and Depreciation (EBITDA). Since about 80% of leveraged loans are also covenant lite, lenders, mostly banks, have very little in credit protection if those companies default. Already at the end of last year, leveraged loan borrowers’ default levels were the highest they had been in two years.

Both stock and bond market signals tell us that banks should anticipate that both individuals and companies will start to default on their debt soon.  Just today, the stock market declined over 6%, the lowest level it has been in three years. As credit quality of both deteriorates this will compel banks to have to raise their regulatory capital levels to help them sustain unexpected losses.

It is important to remember that according to the Federal Reserve back in November, about half of Ame rica’s banks have satisfactory or less than satisfactory supervisory ratings. The stability of these large banks is important to our country. After the financial crisis, the Federal Reserve developed a supervisory program to address systemic risks posed by large banks. According to the Federal Reserve, “Firms with less-than-satisfactory ratings generally exhibit weaknesses in one or more areas such as compliance, internal controls, model risk management, operational risk management, and/or data and information technology (IT) infrastructure. Some firms also continue to exhibit weaknesses in their Bank Secrecy Act (BSA) and anti-money-laundering (AML) programs.”

If the labor market is not offering enough signals to banks’ risk managers that they need to run more stringent stress tests, Moody’s announced yesterday that it changed its Stable outlook on U.S. banks to negative. Specifically, Moody’s analysts stated that “The broad and growing scope of economic and market upheaval unleashed by the coronavirus pandemic will increase the strain on US banks’ operating environment and asset risk. Further, emergency interest rate cuts by the Federal Reserve (Fed) to near zero will increase the pressure on banks’ profitability. The Fed's broad supplemental policy actions will help sustain banks’ already strong liquidity, and their sound capitalization will provide a solid buffer against stress losses. However, in the event of a substantial spread of the coronavirus in the US that causes a deeper, more prolonged economic slowdown, the credit-negative implications for banks will intensify. A significant increase in unemployment would lower borrowers’ repayment capacity and raise banks’ problem loans and credit costs.”

Risk managers should not be focused only on the annual Dodd-Frank Stress Test (DFAST), which is the quantitative component of the Comprehensive Capital Analysis Review (CCAR), due on April 6.  The unemployment scenario released on February 6 for CCAR is 6.5 -10% in the baseline and severe cases. February 6 is already a lifetime ago. Since then the Federal Reserve has cut interest rates practically to zero which will put significant pressure on banks’ net interest margin. Community and regional banks, which by definition are a lot less diversified than globally systemically important banks, will take a significant hit not only from the very low interest rate environment, but also from rapidly deteriorating credit quality conditions of companies and individuals who borrow from them.

For the sake of financial and economic stability, bank regulators must order banks to conduct stress tests now with much more stringent unemployment, housing prices, and commercial real estate scenarios than it requires presently in its 2020 scenarios. In this economic and market environment those scenarios are no longer relevant, because the current reality is already showing us much more stressful scenarios that will impact banks capitalization and liquidity.

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