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Did The Stress-test Standard Change Midstream?

A little over a week ago I flagged a Wall Street Journal piece that vaguely intimated the government had switched its standard for measuring bank capital midway through the stress tests to make the capital hole look smaller. (That's how some prominent bloggers interpreted the piece, in any case.) According to the Journal, the standard that the market and the media had fixated on--tangible common equity--factors in "unrealized losses," while the standard the government actually used (called Tier 1 common capital) does not, accounting for a difference of tens of billions of dollars. (There are other differences between the two measures, but that's the main one.)

While working on a piece about dodgy bank accounting for our latest issue, I had a chance to ask a knowledgeable Fed source about this, and the source unambiguously disputed the idea that tangible common equity (aka TCE) was ever on the table. Now, you'd probably expect this response even if the standard had been changed at some point. But I found the claim pretty credible for the following reasons: 1.) As the source noted, the Fed has historically used a broad measure of capital adequacy called Tier 1 capital. When it decided to play it more conservative for the stress tests and focus primarily on common capital (basically, it decided to not to count preferred stock as part of a bank's capital cushion), it was only natural that it turn to Tier 1 common capital, since the two measures are related and it's very easy to translate from one to the other. TCE, on the other hand, is basically a different unit of measurement. 2.) As the source also pointed out, different people have slightly different concepts in mind when they invoke TCE, so it's not even clear which version of TCE the Fed would have used had it gone that route. Tier 1 common is a much more precise concept, apparently.

At the risk of putting this incredibly crudely, I'd submit the following analogy: If looking at Tier 1 capital is like counting the combined number of red and green jelly beans a bank has on hand, then measuring Tier 1 common capital is like only counting the green jelly beans, while measuring TCE is like measuring the amount of green dye a bank has thanks to all those green jelly beans. If you already know the combined number of red and green jelly beans, it's much easier to just strip out the red ones than to start measuring green dye.

--Noam Scheiber