Raising Bank Common Equity: The Vicious Dilution Cycle

Bank stress tests are now being delayed until the end of next week, not Monday, May 4th, as originally planned (see Bloomberg article).

Source: CFA Smart Brief
The delay is apparently being made as bank executives debate the findings of the tests with examiners. Initial talk was for banks to have tangible common equity equal of about 4 percent of a bank’s assets, with Tier 1 capital coming in about 6 percent. The goal of some regulators is to have common equity to be the dominant element in the bank's primary capital. Regulators are now worried that disclosure of poor results could cause the stocks of the weaker institutions to fall. Really? Is this a surprise? To add insult to injury, banks with low equity will be pressured to add capital, either by raising funds from private investors or taxpayers, or by converting government-held or privately-held preferred shares to common equity. Such a move will dilute existing shares and is sure to produce an undesirable downward spiral, one of which could further weaken banks which have scored low on the stress tests - which will no doubt result in some other type of assistance. Apparently, the government now needs a little more time to untangle the web they have weaved.