In another round of “stress” tests last month, the Fed said Big Banks Pass Muster.

Anyone who has been following stress tests in US or Europe knows full well, the tests were in reality “stress free“.

Confirmation of the undercapitalized state of US banks comes from former Fed Governor Thomas Hoenig. He served as chief executive of the Tenth District Federal Reserve Bank, in Kansas City, for 20 years. Rules limit terms to 20 years. Hoenig is now vice chairman of the Federal Deposit Insurance Corporation.

Undercapitalized, Unsafe, and Unsound

Hoenig’s opinion should carry some weight. And a New York Times Editorial citing Hoenig sounded an alarm today regarding Unsafe and Unsound Banks.

After the latest round of bank stress tests last month, the Federal Reserve announced that, by and large, the nation’s biggest banks would all be able to withstand another crisis without requiring bailouts.

This month, Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation, released data that contradict the Fed’s conclusions.

In the face of Mr. Hoenig’s challenge, the Fed would do well to recall a chapter from its recent history. Before the financial crisis, when Alan Greenspan, then chairman of the Fed, was insisting all was well with the banks, one Fed governor, the late Edward Gramlich, warned of mounting risks. He was ignored.

At issue this time around is the level of bank capital, which reflects the amount of loss a bank can endure before failing (or, if the bank is “too big to fail,” requiring a bailout). According to the Fed’s main measure, capital at the eight largest American banks averaged 12.9 percent of assets at the end of 2014, well above required regulatory minimums.

In contrast, Mr. Hoenig’s calculations show that capital at those same banks averaged only 4.97 percent at the end of 2014.

In a recent speech, Mr. Hoenig noted that under American accounting rules, derivative holdings add $300 billion to the balance sheets of five top banks — JPMorgan Chase, Citigroup, Bank of America, Goldman Sachs and Morgan Stanley. Under international rules, the holdings would add $4 trillion.

History favors Mr. Hoenig’s approach. Gains and losses on derivatives may be offsetting when the economy is stable, but in the financial crisis American taxpayers were forced to hand the banks tens of billions of dollars to make good on derivative bets gone bad. In a healthy system, the banks would hold enough capital to ensure that doesn’t happen again. Do they now? Fed officials seem to think so. They should think again.

Thomas Hoenig on State of US Banks

Let’s take a look at April 2 statements by Thomas Hoenig in the FDIC Release of Fourth Quarter 2014 Global Capital Index.

For the largest U.S. banking firms, the average tangible equity capital ratio – known inversely as the leverage ratio – is 4.97 percent (column 8). In other words, each dollar of assets is funded with 95 cents of borrowed money.

The largest regional and community banks, shown in the last three rows of column 8, have tangible capital ratios ranging from 7.57 to 8.85 percent.  That is, they operate with between 1.5 and 1.7 times more funding from their ownership than G-SIBs do.

“The Global Capital Index illustrates how financial resiliency is still sorely lacking,” Vice Chairman Hoenig said. “The sector of the financial industry with the greatest concentration of assets is the least well capitalized. Plainly put, it operates with the largest amount of borrowed, or as we say, leveraged funding, and thus it is the least well prepared to absorb loss. Yet the primary measure of capital – the risk weighted measure (column 3) — makes the largest firms appear relatively more stable than they really are. The reality is that with too little owner equity funding individual firms, the industry as a whole also is undercapitalized and should one firm fail, the industry continues to be vulnerable to contagion and systemic crisis. It follows that the lack of adequate tangible capital remains among the greatest impediments to successful bankruptcy and resolution.”

The ratios of Tier I capital to risk-weighted assets for all banks (column 3), largest to smallest, are above 10 percent and some of the largest have ratios of more than 15 percent. “This higher capital ratio is achieved by reducing on-balance sheet assets by a pre-assigned risk weight and excluding off-balance sheet assets, such as derivatives. This measure is misleading and overstates the strength of these firms’ balance sheets. No other industry is allowed to make these kinds of adjustments,” Vice Chairman Hoenig said. “The tangible leverage ratio provides a more accurate measure of assets and risks than the balance sheet reported under either GAAP or Basel.”

Banks Not Well Capitalized

Banks are “well capitalized” in the US only by ignoring derivatives. European banks are “well capitalized” by treating all sovereign debt, including Greece, Spain, Portugal, as if it was risk-free.

The reality is banks are undercapitalized globally.

And although taxpayers were forced to cover losses, they shouldn’t have been. The notion that bondholders should never take losses is absurd.

The Fed assumes “derivatives are risk free because they net out”. Hoenig doesn’t buy that argument and neither do I.

A currency crisis awaits.

Mike “Mish” Shedlock