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Could Bank Stress Tests Push US Back Into Recession?

The latest round of bank stress tests could actually do more harm than good to the fragile financial system—even pushing the US back into a recession, a prominent bank analyst believes.

Columns and steps
Columns and steps

Mandated by the Dodd-Frank regulations, the Federal Reserve's annual tests require that the largest banks be able to survive 13 percent unemployment , another 21 percent drop in home prices and a 52 percent plunge in the stock market.

Those are conditions that mimic not only the financial crisis conditions in 2008 but also on some levels — particularly in the associated capital requirements the Fed thinks will be needed for the banks to survive — take the industry back to the 1930s.

For Dick Bove, the closely followed (and controversial) vice president of equity research at Rochdale Securities, the conditions are unfair and will force banks to boost their reserves against possible loan losses even more. That, in turn, will pinch bank profits and tighten credit conditions in an already struggling US economy.

"The banks are back, the banks are in good shape, the banks are ready and able to assist the economy. Then along comes this annual abortion of a stress test," Bove said in an interview. "You're going to see that they're going to have to stop lending money, they're going to have to dump loans, they're going to have to increase cash positions."

"They're going to have to increase capital ratios by shrinking their balance sheet," he added. "Everything they've achieved, everything that we've got to move us forward gets stopped and put in reverse by the stress test."

Bove has been one of the harshest critics of the increase in banking regulation that came about after the collapse of the subprime mortgage market sent the U.S. economy spiraling into recession and Washington scrambling for ways to prevent a reoccurrence.

His positions often sound contradictory — he has told investors to buy bank stocks "hand over fist" while also warning that overzealous regulators could destroy the industry. Several months ago he told investors to get out of stocks completely because of government debt turmoil, but has been adamant that U.S. banks face no serious risk from the European debt crisis.

Fears that the stress tests will seriously hamper banks are not universally shared.

Goldman Sachs said the banks subject to the stress tests have $900 billion worth of "loss absorption capacity," the result of accruing reserves and a slowdown in lending over the past two years. The banks all passed tests that Goldman ran simulating the stress test scenario.

"We believe most banks are well positioned for the 2012 Fed stress test," Goldman Sachs analysts told clients. "Reduced leverage, higher quality assets (lower risk, limited/no prop trading) and higher capital levels relative to prior exams should help banks withstand the stress of the Fed’s exam."

That doesn't mean there isn't substantial concern about the large banks deemed by regulators as Systemically Important Financial Institutions, or SIFIs. They are the too-big-to-fail institutions that nearly capsized the entire U.S. economy during the financial crisis.

Of particular interest during the stress tests are the six biggest — Bank of America , Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo.

Those institutions have underperformed their non-SIFI peers by 14 percent this year in the U.S. When the definition is extended to global banks deemed as SIFIs (but not subject to stress testing), that underperformance number jumps to 24 percent, according to Keefe, Bruyette & Woods.

"We believe that part of this outperformance may be attributed to the lower regulatory burden non-systemic banks face when compared to SIFI banks," KBW said in a recent research note. "We believe the benefits of lower capital requirements, less fee income pressure, less onerous terms for capital deployment, and less European exposure in general could lend support to non-systemic banks, and the relative outperformance may continue into 2012."

Paul Dales, senior economist at Capital Economics in Toronto, points out — like Bove — that the immediate exposure of U.S. banks to European contagion is limited. However, Dales said the big fear is that the crisis spreads to the so-called core European countriessuch as Germany, France and other more stable economies.

"The US is not completely immune to events in Europe," Dales told clients. "Another credit crunch will be the biggest risk hanging over the U.S. economy for the foreseeable future."

For Bove, though, the threat of overreaching on the regulatory front is the biggest threat.

"All year the economy's gotten better, unemployment has come down, corporate profits are soaring, bank profits are soaring, the structure of bank balance sheets has gotten better and better," Bove said. "Everybody says, 'This is a fluke. We know that out there is this great monster which is going to gobble up the American financial system and the American economy, because we know that for a fact and we know that these stocks are no good.'"

It isn't the stocks that are no good, but rather the new regulatory environment, he said.

"These tests request the banks to establish capital plans that will defense them in a Depression environment," Bove said in a note to clients. "This can be done but only if banks shrink their asset by eliminating loans. This will not help the economy and could meaningfully harm it."