The Fed’s Stress Tests Are Meaningless: Citigroup Inc. (C), JPMorgan Chase & Co. (JPM), Barclays PLC (ADR) (BCS)

The Federal Reserve just released stress test results for the nation’s largest financial institutions. It paints an altogether flattering impression of the U.S. banking sector as a resilient, functional financial system; an impression that is not entirely accurate. Also, according to Bloomberg Law, the U.S. Department of Justice is now seeking guilty pleas from bank subsidiaries that were involved in creating the financial crisis. Its stated reason for pursuing the subsidiaries instead of the parent companies is so that investors don’t get spooked and start fleeing the parent company’s stock. To sum it up:

1. We have fixed the systemic flaws in our financial system so that it can weather any storm.

2. We cannot risk prosecuting banks, because the world will end.

Ok, maybe the world won’t end but the Fed is basically saying that it cannot risk endangering a bank’s reputation through direct litigation. Here is why both of the above notions are demonstrably false.

Barclays PLC (ADR) (NYSE:BCS) & UBS AG (USA) (NYSE:UBS)

First, just look at the evidence from the other side of the Atlantic. In June of last year, Barclays PLC (ADR) (NYSE:BCS) was the first bank to be prosecuted on LIBOR manipulation charges. It paid penalties of $200 million to the U.S. Commodities Futures Trading Commission, $160 million to the U.S. DOJ, and PS59.5 million to the UK Financial Services Authority; which all tolled was about 4% of their pre-tax earnings. Soon after, it became obvious that this was not an isolated case but a pervasive culture of interest rate fixing at banks, and sometimes even hedge funds. UBSwas the next to fork out huge sums, with $1.2 billion going to the CFTC and U.S. DOJ, 160 million Pounds Sterling to Britain’s FSA and CHF60 million to the Swiss Financial Market Supervisory Authority.

How have these stocks been performing since?

Here’s a look at their share prices over the last six months:

Obviously they’ve managed significant gains despite the scandal, but how did they do it? Well, they focused on cost-cutting efforts, and although the severity of the cuts vary from bank to bank, the central tenets were the same:

1. Scale back investment banking operations
2. Reduce compensation pools
3. Restructure internal compliance mechanisms

Granted, the financial industry as a whole is seeing gains but the material point is that litigation is not hurting these banks in the short to medium-term, and it will definitely make them safer in the long-term. Barclays PLC (ADR) (NYSE:BCS) and UBS are far from perfect, but the media attention and costliness of their transgressions are forcing them to adapt their behavior. The key is incentives.