Is Another Banking Crisis Staring America in the Face?

Federal Reserve Board Governor Daniel Tarullo.
Federal Reserve Board Governor Daniel Tarullo.

Federal Reserve Gov. Daniel Tarullo said something earlier this week that should cause the ears of every adult in the country to prick up: While America's big banks are in better overall shape than they were just before the start of the 2008 financial crisis, there's still "room for improvement at virtually every firm."

Considering how quickly the big banks started to circle the drain after Lehman Brothers filed for bankruptcy in September 2008, saying the banks are in better shape today than they were then isn't saying much at all.

This announcement by a Fed governor, then, is damning with faint praise at best, and more like a barely disguised warning about the state of the U.S. banking system.

How Banks Fared in Worst-Case-Scenario Tests

Tarullo is the Federal Reserve governor who ran the country's biggest banks through their most recent set of "stress tests." These stress tests were designed to see how the banks would respond to a simulated, worst-case economic scenario -- a 50% decline in the stock market, a spike to 13% unemployment, an 8% drop in gross domestic product, low interest rates, and a European market crisis.

Nineteen banks were tested, all of the "too big to fail" variety. They included Goldman Sachs (GS), Morgan Stanley (MS), Bank of America (BAC), Wells Fargo (WFC), and Citigroup (C). Four failed, with the remainder passing to one degree or another: some coming through strong and others just squeaking by.

Citigroup, to everyone's surprise, failed. For shareholders, that meant the bank couldn't raise its dividend or buy back any shares, two things that make shareholders very happy and boost share prices -- something that makes the banks very happy.

It's an Economically Terrifying Life

When Tarullo said there's "room for improvement at virtually every firm," he was referring specifically to the way in which the banks were managing their capital. And there's the rub. Because if a bank is about nothing else, it's about capital -- how much it has overall, what it does with it, and how much of it can be quickly gotten when the situation suddenly goes south, like it did in the fall of 2008.

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Lehman Brothers had too much debt, had too little capital, and was therefore overly dependent on a system of bank-to-bank overnight lending to remain solvent.

Once word got out that Lehman was in trouble, other banks stopped lending to it. Once that happened, it quickly descended into bankruptcy, starting a chain of events that nearly brought all the rest of the big banks with it.

It was a classic bank run, right out of It's a Wonderful Life, except this time with global economic repercussions.

The Financial Crisis: It's Not Dead Yet

Banks need to have capital on hand, for situations foreseen but mainly for situations unforeseen. And as we all quickly found out, the banking system lies at the very heart of our day-to-day economic existence. When the banks aren't working, nothing's working. Businesses can't get loans, which means they can't buy the equipment they need to stay in business or make payroll. It also means consumers can't get loans, which means they can't buy cars or refrigerators or houses -- the making of which keeps people employed. It's a vicious cycle.

So this is what the stress tests were all about -- sorting out which banks were strong and which still needed help. And that's why, when one of the Federal Reserve's governors says that the banks have shown some significant weaknesses, even after what were supposed to be the most rigorous of stress tests -- we all need to sit up and take notice.

News of the death of the financial crisis has been greatly exaggerated. The recently completed stress tests should really be looked at as a kind of parole, with the idea that the banks will be kept under strict supervision until they prove that they can move freely among the economic populace again without doing themselves, and therefore the rest of us, any harm.

Motley Fool contributor John Grgurich owns no shares of any of the companies mentioned in this article.

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