Following the release of the Dodd-Frank Act supervisory stress test 2015 (DFAST 2015) results last week, the Federal Reserve approved the capital plans of 28 financial institutions out of 31 in the Comprehensive Capital Analysis and Review (CCAR). However, the capital plans of two of the remaining three have been rejected based on certain qualitative concerns, while the third one received conditional consent on resubmission of its plan by Sep 30.
The Fed’s nod to most major U.S. banks reflects stability in the banking system to a great extent. All the bank holding companies (BHCs) with $50 billion or more in total consolidated assets are part of DFAST 2015. Notably, 31 BHCs that submitted their capital plans to the Fed in Jan 2015 account for approximately 80% of total banking assets in the country.
The banks now have the privilege to increase dividends and buy back shares. Amid concerns that banks might not have sufficient capital to counter another financial crisis, these were asked to submit their capital plans to the Fed. The banks were intimated that payment of higher dividends will be restricted if they fail to meet the requirement of 5% ratio of core capital to risk-weighted assets among other requirements.
Root of the Capital Rules
Currently authorized under the Dodd-Frank financial services law, the stress tests were first introduced after the 2008 financial crisis. During this economic downturn, big financial institutions like Lehman Brothers collapsed and several other big banks were on the verge of a meltdown. Such a situation compelled the U.S. government to infuse billions of dollars into credit markets and save the entire financial system from crumbling.
Stress tests have been annually conducted since 2009. The environment of the last 5 rounds of stress tests along with the latest one is quite dissimilar to the Fed's first round. The first round, conducted when the country was teetering under tremendous recessionary pressure, was aimed at estimating how much the banks would lose if the economic downturn proved deeper than expected. Since then, the stress test rounds are precautionary measures amid an economic recovery.
The Federal Reserve’s latest stress test scenario projections include input data supplied by the 31 banks participating in DFAST 2015 and models created by the regulatory staff and evaluated by a group of Fed economists and analysts. These models were developed with the intention to inculcate the impact of the macroeconomic and financial market factors that are included in the Supervisory Stress Scenario and distinctive factors of the banks’ loans and securities portfolios, trading as well as other factors affecting losses, revenue and expenses.
Moreover, the Fed's stress test was conducted to find out whether the banks have enough capital to survive another financial crisis, including a hypothetically 10% unemployment rate, more than 60% fall in stock prices, more than 25% drop in housing prices along with an economic downturn in developing Asia.
Further, severe recession in the U.K., Europe and Japan was featured along with expected losses of $490 billion at the 31 bank holding companies during the 9 quarters of the theoretical stress scenario. Further, tier 1 common capital ratio was anticipated to fall from an actual 11.9% in the third quarter of 2014 to 8.2% in the hypothetical stress scenario. The requirements in the sixth round of the stress test was tougher compared with the prior ones.
Additionally, as per the Dodd-Frank Act, bank holding companies participating in the Fed’s stress test rules have to conduct two company-run stress tests each year. Moreover, they have to publicly unveil a summary of the results of the company-run stress tests conducted under the strictly adverse scenario given by the Fed.
Successful Banks
Wells Fargo & Company WFC, Citigroup Inc. C, Fifth Third Bancorp FITB, The Bank of New York Mellon Corp. BK, U.S. Bancorp USB, The PNC Financial Services Group, Inc. PNC, Capital One Financial Corp. COF and State Street Corp. STT are among the major banks that have received clearance from the Fed to raise their dividends or repurchase shares.
However, among other major banks, The Goldman Sachs Group Inc. GS, JPMorgan Chase & Co. JPM and Morgan Stanley MS submitted adjusted capital plans last week, which got approval. The resubmission was led by the first round stress test results last week.
Further, Bank of America Corp. BAC received contingent approval on submission of its revised capital plan by the end of Sep 30 as certain loopholes in its capital planning processes were addressed by the Fed. Further, Fed believes BofA lacks in loss and revenue modeling practices and internal controls. However, BofA is still allowed to initiate a $4 billion share buyback plan.
Banks on Shaky Ground
Among 31 bank holding companies which submitted their capital plan to the Fed in Jan 2015, the capital plans of U.S. units of Germany-based Deutsche Bank AG DB and Spain’s Banco Santander, S.A. SAN have been rejected by the Fed based on certain “qualitative” reasons. The Fed holds the opinion that these banks have loopholes in their capital planning processes.
Recovery on the Way
This, however, is not the end. The major banks will have to undergo the Fed’s stress test once every year. These would help build up the weak capital levels of banks, which are a looming threat to the economy. Also, this could ultimately translate to less involvement of the taxpayers’ money for bailing out troubled financial institutions.
However, the government must necessarily frame certain policies so that every industry participant contributes to the overall profitability. While the bigger banks benefited greatly from the various programs launched by the government, many smaller banks are trying hard to catch up.
The banking sector presented an improved picture in 2014 compared to 2013 and 2012. Nagging issues like depressed home prices, loan defaults and unemployment levels are not so prominent compared to the last few years.
Though economic uncertainty still lingers, banks are actively responding to every legal and regulatory pressure. In fact, this has positioned the banks well to encounter impending challenges. As the sector is undergoing a radical structural change, it is expected to witness headwinds in the near to mid term. However, entering the new capital regime will significantly improve the industry’s long-term stability and security.
Nevertheless, the approval from the Federal Reserve to increase dividend payment and accelerate the share buyback program will definitely help banks attract more investments going forward. Hence, it can be said the economy is on the track to recovery.
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