The Market Knows More About Banks Than Stress Testing Reveals

The Federal Reserve released the results of the “DFAST” stress tests two weeks ago, but one risk management firm, Kamakura Corporation, thinks the market does a far better job predicting financial calamity than the stress tests. Kamakura, which is a consultant to the FDIC and U.S. Treasury that provides quantitative analysis of interest rate and credit risk, argues, “The marketplace considers all scenarios, not just three as in the Fed’s CCAR [Comprehensive Capital Analysis and Review] stress tests.”

Kamakura analyzed trading activity taking place on the Monday following the release of the stress test results and concluded that an analysis of market-based factors contributes a far deeper understanding of bank credit spreads than the results of the stress tests when assessing an institution’s ability to honor its commitment to making timely interest and principal payments. Why? In Kamakura’s words, “The marketplace invests cold hard cash to price various financial institutions’ promises to pay.” Kamakura analyzed 27 of the 31 financial institutions required to submit stress test results, and attributed only a small percentage increase in variation of credit spread predictive power compared to a purely statistics-based model. A one percentage point increase in Basel III Tier 1 capital ratio, for example, explained around 5 basis points of credit spread variation, whereas their statistical model, crafted using public data exclusively, explained about 82% of credit spread variation.

This matters for portfolio management because institutions that meet the Federal Reserve’s stress test requirements , or “pass,” are somewhat validated via this very process for having superior credit quality, partly due to increased regulatory oversight. But the market disagrees. Kamakura, in another article, notes that 25 financial institutions, including Berkshire Hathaway and CME Group, have lower credit spreads than the best “Too Big to Fail” banks. Moreover, when Kamakura ranked bonds based on reward-to-risk ratio (an analogous approach to the concept of the Sharpe Ratio), some of the most heavily-regulated banks (including Citigroup and Bank of America) had bonds ranked near the bottom of the list (others offer compelling reward-to-risk ratios, but did not trade in sufficient quantities or at all on the day Kamakura did its analysis).

At SNW, we apply an approach similar to Kamakura’s by leveraging quantitative metrics that rely on equity trading data and factors specific to the bond market, like leverage and interest coverage, for determining relative value. Using this approach, portfolio holdings like Aflac and NASDAQ consistently rank higher than financial alternatives that are subject to substantial regulatory oversight. We factor in the DFAST stress test results, but apply a sizable haircut to their incremental ability to predict variations in credit spreads over and above the marketplace.

Sources: Kamakura Corporation, Federal Reserve, SNWAM Research