Federal Reserve stress test update
Morgan Stanley and BMO Financial have produced the weakest Tier 1 leverage ratio in the Federal Reserve stress tests. Citigroup and JP Morgan Chase, however, have shown gains in both Tier 1 common equity ratios and Tier 1 leverage ratios. While Wells Fargo has demonstrated little improvement, most US banks have benefitted from the anticipation surrounding the tests as stocks began to rise, shown as shares of Citigroup rose 4.2%. 

(Reuters) - Big US banks are proving themselves to be stronger and sounder in an annual regulatory stress test, even as the Federal Reserve changes doomsday scenarios to keep them on their toes.

(Adds analyst comment and detail of JP Morgan result)

On Thursday, the Fed said each of the 33 US banks that underwent its standardized stress test were able to stay above minimum required capital levels in severe economic and market conditions. Banks that participated last year also passed, but their capital levels have largely improved since then.

Overall, the 33 banks would suffer US$385bn in loan losses over nine quarters under the most severe scenario, the Fed said. In aggregate, a key ratio measuring high-quality capital against risk-weighted assets, known as the Tier 1 common equity ratio, would drop to a low of 8.4%. That is well above the 4.5% minimum set by regulators.

(Click here to see how the banks performed)

Since the Fed started stress testing banks in 2009, capital levels have risen and credit quality has improved, with bad loans rolling off the books. The Fed creates new inputs for market and economic chaos each year, and shocked investors in January when it included negative interest rates in the worst-case scenario.

“Today’s results are particularly notable given the more stringent test assumptions above last year’s test,” said Richard Foster, senior counsel for regulatory and legal affairs at the industry trade group Financial Services Roundtable. “Banks now hold extremely high levels of capital and liquid assets as compared with historical averages.”

Analyst Steven Chubak of Nomura Securities said, “For the big banks, the results were just incredibly robust.”

Capital levels surged from last year’s results as the Fed gave the big banks credit for more revenue at the end of test period than some of the banks themselves expected, Chubak said.

However, Thursday’s results are just one part of the Fed’s annual stress test process, and do not even offer a glimpse at what many investors really want to know: Will banks be able to use more capital for dividends and stock buybacks?

This first test – called the Dodd-Frank Act Stress Test, or DFAST – is part of the sweeping financial reform law passed in the wake of the 2007-2009 financial crisis. It relies on standardized assumptions about capital levels and distributions for the tested banks, allowing for a consistent view across the industry.

Next week, the Fed will release results of a more nuanced examination known as the Comprehensive Capital Analysis and Review, or CCAR. That test evaluates banks’ individually tailored plans for surviving a crisis.

The Fed gives each bank a pass or fail grade for CCAR, based not only on hard numbers, but also on qualitative measures. That means the Fed can fail a bank because it did not approve of how management went about the capital planning process.

“DFAST is sort of like a dress rehearsal for the CCAR,” said Ernie Patrikis, a partner at the White & Case law firm and a former bank regulatory official at the Federal Reserve Bank of New York.

Thirteen banks have failed CCAR since the Fed began disclosing results, according to research firm Trepp.

In an analysis carried out before DFAST results were released, Trepp analysts predicted two-thirds of the banks will likely be allowed to increase their dividends. The percentage approved for dividends has been ticking down from 72% in 2013 to 67% in 2014, and 61% in 2015.

“Banks generally are doing pretty well on earnings, so there is capacity to increase their dividends,” said Matt Anderson, managing director at Trepp.

Negative rate pain

The Fed will announce CCAR results on June 29. Failures are embarrassing, and the Fed allows banks to resubmit capital plans based on DFAST results to give them a second chance to pass. They have until Saturday to do so.

Of the 33 banks that took part in DFAST, Huntington Bancshares Inc produced the lowest minimum Tier 1 common equity ratio, of 5%, under a severely adverse scenario. Morgan Stanley and BMO Financial Corp produced the weakest Tier 1 leverage ratio – another measure of capital strength relative to assets – of 4.9%, under that scenario.

Banks also released their own stress test results, based on inputs set by the Fed. The figures did not necessarily match up. For instance, Morgan Stanley’s own capital ratios under severe stress were higher than the US Federal Reserve test result, as were Wells Fargo & Co’s and BMO’s.

Banks that look marginal in DFAST may well have submitted capital plans that include the issuance of securities that would dramatically affect their capital scores. And, banks with strong numbers can still fail CCAR because the Fed considered the quality of their capital planning faulty.

Citigroup Inc, for example, has had surprising results for both reasons in the past. This year, Citi racked up big gains, with its Tier 1 common equity ratio rising to 9.2% from 6.8% and its Tier 1 leverage ratio improving to 6.9% from 4.6%.

JP Morgan Chase & Co saw its Tier 1 common equity ratio rise to 8.3% from 6.3%.

Wells Fargo improved less, possibly because it relies more on consumer deposits for funding and therefore could have been hurt more by the negative interest rate scenario. The Fed generally assumes that banks would not be able to pass along negative rates to consumers by charging them for holding their deposits.

Bank stocks rose on Thursday in anticipation of the stress test results, as well as the Brexit vote. Citigroup was one of the biggest beneficiaries, with its shares rising 4.2% to close at US$44.46, and gaining another 2.9% in after-hours trading.

Reporting by Lisa Lambert and David Henry