03/15/2012 03:00 pm ET Updated May 14, 2012

The Fed's No Stress Stress Test

Today's Wall Street Journal carried a cover story, "Stress Tests Buoy U.S. Banks." In fact, the stress tests showed exactly the opposite. Of the 19 banks, only three had Tier 1 capital above 10 percent. Lehman Brothers had Tier 1 capital of 11 percent on Sept. 12, 2008, three days before it declared bankruptcy. So 16 of the banks are in a riskier position than was Lehman when its creditors pulled the plug. Indeed, of the 16 banks with less than Lehman's level of Tier 1 capital, none had Tier 1 capital above 8 percent and eight had Tier 1 capital below 6 percent.

Even the three banks that pass the Lehman stress test may be taking on extreme risk. Tier 1 capital refers to the ratio of a bank's common equity to its risk-weighted assets. Safe assets get zero risk weights. Hence, a bank can hold mostly safe assets and easily report a high level of Tier 1 capital because its owners equity is being divided by a small number -- its risk-weighted assets.

But the notion that there are "safe" assets and "risky" assets is belied by the facts. Back in 2005, the sovereign bonds of Ireland, Greece, and Portugal were rated AAA. Today they are rated junk. And ratings can be wrong right up to the point that they are made right. Lehman Brothers bonds were rated AAA almost to the point of its collapse by our incredible rating companies.

A U.S. bank that today were to hold nothing but long-term Treasuries would have an astronomical Tier 1 capital level even though it might be leveraged 33 to 1, which is the Basel III accepted maximum. That means that only a 3 percent drop in the value of its Treasuries would wipe out all its capital and leave it insolvent. Given the Fed's near quadrupling of the monetary base since 2007 and the fact that the U.S. government has, arguably, the largest fiscal gap, scaled by GDP, of any developed country, counting on Treasuries to fall by at least 3 percent is a very safe bet. The fiscal gap is the difference between a government's liabilities (its official debt and the present value of its projected non-interest discretionary and entitlements spending) and its assets (the present value of its projected taxes).

The message here is that neither the Fed nor the Treasury is to be trusted when it says a given bank or the banking system as a whole is safe. In fact, our "trust me" banking system is unsafe at any speed as 27 million out-of-work or short-on-work Americans can attest. When no one can tell what a bank is doing with his/her money, fraud, suspicions of fraud, or suspicion of suspicions of fraud can lead to instant bank runs even in the case of banks, like Lehman, that can clear the government's no-stress stress test.

The reason is that, at some point, no one believed Lehman's valuation of its assets (even though the Fed, SEC, and Treasury were closely monitoring its books from March 2008 on) or no one believed that anyone else believed Lehman's valuation or everyone believed Lehman had the assets it said it did, but everyone decided everyone else was running on the bank and they needed to run as well. In the end, Lehman's creditors are recovering only 20 cents on the dollar, so its Tier 1 capital ratio was one thing, assuming no disorderly resolution of the company, and quite another thing assuming a disorderly resolution.

There is a way to make Wall Street safe for Main Street. It's called Limited Purpose Banking. The plan has been endorsed by George Shultz, Bill Bradley, Jeff Sachs, Kevin Hasset, Simon Johnson, Ken Rogoff, Michael Boskin, Naill Ferguson, Robert Reich, Bill Niskanen (before his recent death), five Nobel prize winning economists (George Akerlof, Robert Lucas, Edmund Phelps, Robert Fogel, and Edward Prescott), Steve Ross (the father of Arbitrage Pricing Theory), Jagdish Bhagwati, and the list goes on.

There is only one Presidential candidate who is telling the truth about Wall Street and wants to implement Limited Purpose Banking. To learn more about that candidate, please go to And to learn more about Limited Purpose Banking and have the option of endorsing it, please go to