Fed stress test: Success for most of the big banks
The Federal Reserve announced its annual stress test results for the banking system recently. The financial markets watch the results very carefully for any deficiencies or changes in the outcome. Overall the test revealed that the banks are in much better shape than in previous years. The test showed that of the 31 firms examined, representing 80 percent of domestic banking assets, most of the banks are in good shape, and their capital plans were approved this year.
The results of the test’s two parts were announced a week apart this year. The results of the first part, which are more quantitative in nature, were released March 5, and all 31 banks passed. The Comprehensive Capital Analysis and Review (CCAR) test, whose results were released a week later, evaluated capital planning process and capital adequacy of financial institutions and was more qualitatively focused. Only 28 banks passed this round. The CCAR results are more closely watched, since they help shareholders predict whether they will be rewarded by the raising of dividends or the buyback of shares. The capital plans for Bank of America were approved conditionally upon the presentation of the final capital planning process by the end of September.
The Fed rejected the plans of Santander Bank and Deutsche Bank, however. This is the first year of tests for Deutsche Bank conducted by the Federal Reserve, and they were expected to fail before the results were announced. Interestingly, Deutsche Bank and Santander passed the European Central Bank stress test conducted in November with very good margins. The official statement from the Fed reads into the fact that Deutsche Bank was “adequately capitalized” but had problems in its “risk management.” Santander failed this test for the second year in a row.
A new set of “severely adverse scenarios” was introduced as part of the test this year. The worst-case figures are used for more prominent variables, such as unemployment rate, real GDP growth rate and Dow Jones Total Stock Market Index. Another notable change to this year’s test was the introduction of the common equity Tier 1 capital ratio. This measures the bank’s financial strength, comparing core equity capital with risk-weighted assets.
The results were a mixed bag. The five regulatory ratios that were used to measure the performance were Tier 1 common, Tier 1 risk-based capital, total risk-based capital, Tier 1 leverage, and the newly introduced common equity Tier 1 capital ratio. This is the first year in which all the banks managed to pass the Tier 1 common ratio requirement. However, three of the top five banks failed other regulatory requirements, showing that the “severely adverse scenarios” focused primarily on corporate defaults. This affected the big banks more than others because they focus more on trading and capital markets. This also explains the lower Tier 1 common ratios for most of the big banks compared with their smaller regional banking peers. However, Citigroup turned out to be a silver lining this year. After failing the test last year, it was under close watch by shareholders. It passed the test this time and announced a dividend payout and share buybackafter the results were released.
This year’s test has boosted the morale of most of the big banks. The Fed has approved most of their capital plans, an important measure to lift the banks’ return on equity. Despite minor hiccups with the results of some, most of the big banks fared well and are on track to either distribute dividends or buy back shares to boost their shareholder wealth.