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Dec 01, 2011

Rising fear over bank stock prices calls for forceful leadership

Andrew Atkeson (left) is Stanley M. Zimmerman Professor of Economics and Finance and director of the Business Economics Program. William Simon is a visiting professor at the School of Law. This op-ed was orignally published on Nov. 28 in the Wall Street Journal.
 
 
The consensus among public officials and financial experts that the U.S. economy is gradually recovering may be too optimistic. There are emerging signs in the stock market that the U.S. economy is about to face financial headwinds that may lead to another credit crisis and recession next year. The recent volatility in bank stocks is a signal that U.S. banks, large and small, are not as healthy as many analysts assume.
 
Banking is a game of confidence. So if the investing public is uncertain about the health of bank balance sheets, its uncertainty can turn into fear, setting the stage for a banking panic.
 
This dynamic has played out twice before over the past 85 years — in the Great Depression and the panic of 2008-09 — with devastating consequences for the broader economy. Over the past three months, investor uncertainty about the soundness of bank balance sheets, manifested in the daily volatility of stock prices, is back up to levels seen historically only in advance of these two great crises.
 
The volatility of bank stock prices from one day to the next depends on investor perceptions of the riskiness of the assets held by banks. In tranquil times, when investors feel that bank portfolios are reasonably safe and not excessively leveraged, daily volatility is low. When investors are uncertain about the soundness of bank balance sheets and about the adequacy of bank capital, then daily volatility rises in bank stock prices to double or triple their normal levels.
 
When uncertainty turns to panic, as it did in 1929-33 and again in 2008-09, the volatility in the daily movements of bank stock prices can shoot up to seven or eight times their normal levels. When this occurs, the damage radiates quickly from the banks to the broader economy. In normal times, volatility hovers below 1 percent, occasionally rising as high as 2 percent, and rarely rising above 3 percent unless a serious crisis is at hand.
 
Volatility spiked to an unprecedented level — nearly 9 percent — with the market crash of October 1929, indicating widespread panic among investors. The panic moderated after the initial crash, but then built again steadily, rising to 4 percent in 1932 and to 5 percent on a sustained basis in early 1933. By this time, the banking system had essentially collapsed, causing newly elected President Franklin Roosevelt to declare a nationwide bank holiday in an attempt to stem the panic. Afterward, the volatility in bank stocks steadily declined to more or less normal levels by 1935, then spiking upward again in the recession of 1937-38.
 
After World War II, bank stock prices were stable for decades, and their volatility never approached the telltale 3 percent until the stock market crash of Oct. 19, 1987. On that occasion, the measure spiked to Depression-era levels, giving investors a fleeting scare.
 
Over the last 20 years, however, with deregulation of financial institutions, the daily movements in bank stocks have become more volatile and, interestingly, are now more closely correlated with economic downturns. This volatility increased in 1990 with the recession that began in midyear, spiked again in late 1998 with the Russian default, and once again shortly thereafter with the bursting of the "tech bubble" and recession in 2000-02.
 
Bank stock volatility increased again in 2007 in much the same pattern as it did in the late 1920s. It rose to extreme levels in 2008 and 2009 as uncertainty gave way to panic in the midst of the financial crisis.
 
From mid-August through last week, bank volatility has been over 3 percent. The market for bank stocks is now sending a bright red warning signal that conditions are ripe for another potentially disastrous financial panic.
 
This extraordinary volatility is not limited to the stocks of large banks but extends to small and midsize banks as well. For example, the volatilities of the daily stock returns of indices of regional and smaller bank stocks have also been hovering around 3 percent since mid-August, including the KBW Regional Bank Index (KRX), S&P's bank the Nasdaq bank stock index (IXBK), and the ABA Community Bank index (ABAQ).
 
What can be done?
 
Throughout history, forceful leadership has been the key to restoring public confidence in the banking system. Without it, there is the risk that mounting uncertainty will lead irresistibly to fear and panic, with well-known consequences for the broader economy. This leadership now can only come from the Federal Reserve and the U.S. Treasury.
 
Given the extraordinary danger, regulators should take immediate steps to restore the investing public's confidence in our banking system — without waiting for European officials to deal with their crisis or for Dodd-Frank provisions and revisions to Basel capital standards to be fully articulated and implemented.
 
The Fed took a useful first step last week in announcing a tough new stress test. This time around, a larger number of banks will be required to prepare plans for adequate capital under severely stressed macroeconomic and market scenarios, and the results will be made public.
 
There is no silver bullet for calming the volatility in the market for bank stocks over the past three months. But the Fed's best shot is to apply this latest stress test broadly across banks both large and small and to insist that banks put forward clear plans to build up much stronger capital positions soon.
 
In addition — and perhaps more importantly — banks should be required to have much higher levels of common equity to reduce their leverage and their incentives to take risks. The recent spike in the volatility of bank stocks is telling us that the banking system is still too highly leveraged and that investors are fearful for the soundness of our banks.
 
The time to restore confidence is now.