By Joseph Moss – joseph.moss@internationalbanker.com
The 31 largest banks of the United States received at least one thumb up from the US Federal Reserve after sailing through the first phase of their most recent round of stress tests, legislated under the Dodd-Frank Act. The Fed has been conducting these tests for the country’s most prominent banks since 2009, in response to the global financial crisis, in an attempt to ensure that taxpayers are not again put on the spot to bail out failing banks. The tests are designed to determine how well the banks would withstand another economic crisis of a similar or even greater magnitude.
However, the Fed isn’t finished with the banks just yet. The next step is for the central bank to approve or decline each bank’s request, if made, to return capital to investors through increasing dividends or buying back shares. Its decisions will be based on how a particular bank would be affected if it takes one or both of these actions, especially in terms of coping with another deep recession should it occur. Raising dividends can be costly for a bank, and the Fed is keen for each bank to hold onto adequate capital reserves to withstand a severe recession. However, dividends also attract investors. Citigroup, for example, has in the past seen its planned dividend and repurchase plans squashed by the Fed.
The stress tests involve a scenario with 28 variables, during which the country endures a recession of historic proportions. Unemployment jumps to 10 percent, home prices drop by 25 percent, the stock market falls by close to 60 percent, a notable rise occurs in market volatility. Exchange rates and income levels are sent into a tailspin. After the dust settles, capital (a bank’s cushion against losses) is compared against projected losses to ensure that it is adequate to withstand the onslaught.
According to the results, the 31 banks (all with $50 billion or more in total assets) tested would suffer a combined loss of nearly half a trillion dollars over 27 months. These losses would bring capital down from 11.9 percent of loans to 8.2 percent by the end of 2016, which is much greater than the 5.5 percent level held at the start of 2009 after the advent of the 2008 financial crisis and last year’s 7.6 percent, showing that banks have steadily been building capital reserves in response to Fed requirements.
The banks that endured the tests included the four largest: Bank of America Corp passed with a minimum Tier 1 ratio of 7.1 percent , Wells Fargo with 6.9 percent, Citigroup Inc. with 6.8 percent, JPMorgan Chase & Co with 6.3 percent. Other big players included Morgan Stanley, also at 6.3 percent, and Goldman Sachs, relatively low at 5.8 percent, making it one of the least capitalized of the big banks. Most of the banks did well in last year’s round of tests as well, with the exception of Zions Bancorp of Salt Lake City, which failed. This year Zions managed to squeak through.
The Fed views the results as an indication of the gradually improving state of the industry. “The largest US-based bank holding companies continue to build their capital levels and to strengthen their ability to lend to households and businesses during a period marked by severe recession and financial market volatility,” according to a recent statement released by the central bank.
Over time, the Fed plans to add more dimensions to its stress testing, such as including more emphasis on stressed leverage ratios.