WASHINGTON—Big banks will get a peek over the next two weeks
into how federal regulators judge them: whether they are deemed
safe enough to endure a severe downturn, and whether they have
demonstrated enough prudence this year to raise shareholder
dividends.
On Thursday, the Federal Reserve will release round one of its
annual "stress tests," which rely on hypothetical scenarios. The
more important day is next Wednesday, when the Fed releases the
full results of the tests, including any capital restrictions.
Investors will care more about the second round of test results
because those will ultimately determine whether a bank can increase
its payout to shareholders.
The Fed is running this version of the stress tests for the
sixth time, but each year the parameters shift slightly, so last
year's results are no guarantee of performing similarly this
year.
Banks spend millions of dollars and hire thousands of people to
meet compliance efforts meant to pass the stress tests, but success
can sometimes be elusive if they misunderstand the Fed's latest set
of expectations—and the process can be all the more surprising when
supervisors no longer find a bank's previously approved process
adequate.
It becomes imperative to know: "Will the Fed raise the bar on
practices they found OK last year but won't this year?" said David
Wright, a former Fed official and now a managing director at
consulting firm Deloitte & Touche LLP's banking and securities
regulatory practice.
The Fed is assessing 33 institutions this year—up from 31 last
year—both U.S.-based banks and the U.S. units of big global
banks.
Among the big questions this year will be the performance of the
newcomers—TD Bank, the U.S. unit of Canada's Toronto-Dominion Bank,
and Bank of the West, owned by France's BNP Paribas SA—and how
other foreign-owned banks will fare.
Foreign banks have struggled to meet U.S. regulators'
expectations for risk management. Two large European banks,
Deutsche Bank AG and Banco Santander, were the only two to fail
last year's stress tests, over shortcomings in how they measured
and predicted potential losses and risks. Bank of America Corp.
didn't fail but was asked to revise its capital plan before being
allowed to issue a dividend to shareholders; 29 banks passed.
The central bank has said it designed the tests to force banks
to adjust to a shifting regulatory environment to minimize any
chance of their complacency and to protect against potential
financial shocks, while encouraging them to improve their data,
models, and risk management capability.
Many bank executives consider stress tests something of a black
box—intentionally constructed by the Fed to keep banks from trying
to game them. And while regulators strive to better set
expectations, some in the industry still criticize the opaqueness
and credibility of the Fed's models.
U.S. regulators have sought to make the process more
transparent, providing additional guidance while also maintaining a
dialogue over the course of the year rather than packing the entire
process into a six-week period, potentially minimizing any
uncertainty.
"The Fed would prefer the firms not simply try to check the box
for having met regulatory expectations, but rather have broader
improvements in their capital planning capabilities," said Mike
Alix, a partner at consulting firm PwC and a former official at the
Federal Reserve Bank of New York, where he oversaw stress tests and
capital planning. "There needs to be continuous improvement—no firm
should rest on its laurels."
There have been cases in the past where banks passed the Fed's
stress tests and then later failed. HSBC North America Holdings and
RBS Citizens Financial Group passed in 2013, but were rejected the
following year.
"Every year when the yard stick comes out [the question] is: Are
people continuing on the glide path, or did they stall in some
areas along the way that are significant enough that their plan
needs to be adjusted?" Mr. Wright said.
The stress tests examine two critical aspects of the largest
financial institutions. First, whether banks hold enough
capital—money raised from investors or earned through profit—to
withstand severe economic stress in the financial system. And
second, whether banks have the appropriate internal processes to
identify and measure risk when considering their own capital
planning. The Fed can reject a bank's plan to pay out shareholders
on either basis.
The initial results on Thursday will show the capital levels of
the firms during a hypothetical severe economic downturn, including
a 10% unemployment rate and a negative yield for U.S. Treasurys.
These will exclude banks' actual plans to offer shareholders
dividends or stock buybacks. Rather, they will show the impact of
severe stress on banks' revenue and total loan losses from
mortgages and credit cards. Thursday's results also won't draw any
conclusions on whether a bank will be barred from digging into its
own capital to pay out profits to shareholders through dividends or
stock buybacks.
Next week, banks will be tested using the same scenarios, only
this time institutions' actual capital distributions will be
included in the exercise, providing a fuller picture.
The eight largest U.S. banks undertake an additional step by
calculating the impact of a default by their single largest
counterparty on their balance sheets. Those same institutions, most
of which have extensive trading operations will run an additional
global market shock when vetting if they hold enough loss-absorbing
capital.
Banks will have the opportunity to save face in the coming days.
Institutions can make a one-time adjustment to their capital plans
if they learn from regulators that they fall below the minimum
thresholds after the first round. The so-called mulligan taken by
banks to scale back their capital plans will be disclosed as part
of next week's stress-test results.
The Fed is considering making changes to the annual exercise to
lessen the burden on midsize traditional banks with assets between
$50 billion and $250 billion, while simultaneously making the
central bank's stress tests tougher for the eight largest U.S.
firms.
Write to Donna Borak at donna.borak@wsj.com
(END) Dow Jones Newswires
June 22, 2016 07:55 ET (11:55 GMT)
Copyright (c) 2016 Dow Jones & Company, Inc.
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