In what has become a rite of spring, the Federal Reserve announced the outcome of the 2014 round of annual bank stress tests in March. (The banks perform the stress tests again internally about mid-year.) Recall that, in its mission to ensure the soundness of the nation’s banks and the stability of the financial system, the Fed began conducting its annual stress test exercise in the aftermath of the 2007-2009 financial crisis.
The first part of the stress tests aims to gauge whether, over a nine-quarter test horizon (from October 2013 to the end of 2015), a bank would have enough capital, as measured against its risk-adjusted assets, to enable it to function under tough hypothetical economic scenarios described as adverse (which assumes a sharp rise in long-term interest rates) and severely adverse (which envisions deep recessions in the United States, Europe, and Japan; a spike in unemployment; and significant declines in stock and home prices). The Fed believes that capital is important to banks “because it acts as a cushion to absorb losses and helps ensure that losses are borne by shareholders, not taxpayers.”
The second part of the tests evaluates the banks’ capital management and planning processes, including whether each institution takes its unique risks into account in its planning, and whether a company’s plans for dividend distributions and stock repurchases are prudent. The banks must pass this portion of the tests, which is more subjective, before they are permitted to raise dividends or buy back stock.
The stress tests have evolved since their inception in 2009, and probably will continue to do so. Whereas only 18 banks participated in the 2013 stress tests, the 2014 round included all bank holding companies in the United States with over $50 billion of assets, or 30 companies in all. In addition to the largest banks, like Bank of America (BAC) and JPMorgan Chase & Co. (JPM – Free JPMorgan Stock Report), a number of sizable regional banks, including HuntingtonBancshares (HBAN) and M&T Bank (MTB), underwent the stress tests for the first time this winter.
Some believe the stress tests have become more difficult over the years, but bank regulators may just be getting better at honing in on potential areas of risk. In the 2014 tests, banks were asked to estimate possible losses from a hypothetical default by their largest counterparty. The capital ratios generated by the first part of the stress tests now reflect stricter capital standards that are being phased in by 2019.
So how did the banks do on the 2014 stress tests? On the whole, well. Although the tests indicated that the 30 banks would experience sharp drops in their core capital ratios, and would report substantial losses in the tough hypothetical environment, the Fed said the banks “are collectively better positioned to lend . . . and meet their financial commitments in an extremely severe economic downturn than they were five years ago.”
Of the 30 banks, only Zions Bancorporation (ZION) failed the first quantitative part of the stress tests, reporting a core Tier 1 common capital ratio of only 3.5%. Note, however, the stress test was Zions’ first, and it may take time for the bank to get a sense of what regulators expect. The company recently sold securities that it figures might contribute to projected losses in the stress tests. Zions indicated that it will resubmit its capital plan to the Fed. Meanwhile, Ally Financial, the former General Motors Acceptance Corporation, the worst performer in the 2013 stress tests (with a core capital ratio of 1.5% last year), showed the most improvement, increasing this metric to 6.3% this year.
Meanwhile, so-called trust banks, like Bank of New York Mellon (BK), Northern Trust (NTRS), and State Street (STT), had the strongest capital ratios. These institutions mostly provide services and manage money. They don’t have a lot of loans, which adds risk, and have smaller asset bases than other big banks, which boosts their capital ratios.
The second part of the stress tests, the assessment of banks’ capital plans and risk-management processes, is more subjective. Five of the 30 banks failed this portion of the tests, among them Zions, due to low capital ratios; Citigroup (C), apparently for qualitative reasons, possibly its planning processes; and three subsidiaries of foreign banks: HSBC North American Holdings, RBS Citizens Financial Group, and Santander Holdings USA. The Fed suggested that it has “heightened expectations’’ for the largest banks, like Citi. Citi will repeat the stress test in a few months, but most don’t expect it to get permission to raise its dividend in 2014.
On the other hand, Bank of America, which slashed its dividend at the start of the financial crisis and hasn’t been allowed to increase the payout since then, was approved to raise its payout after it altered its plan and resubmitted it to the Fed. It subsequently announced a hike in the payout, from a quarterly rate of $0.01 a share to $0.05, and authorized a new $4 billion stock buyback program.
In all, the stress tests, while not perfect, are useful since they force banks to take a good look at their capital cushions and take corrective actions if necessary. Investors may want to pay attention to the stress test results since they determine whether a bank can return capital to shareholders and provide insights regarding the bank’s financial health.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.