JPM JP Morgan Chase and Co

In first round of Fed's stress tests, all 33 firms pass bar; second round is next week

By Ryan Tracy and Donna Borak 

WASHINGTON -- The largest U.S. banks have significantly bolstered their defenses against an economic downturn, and could continue lending even during a deep recession, the Federal Reserve said.

That signals that many of those institutions will win regulators' approval next week to boost dividends to investors.

In the first part of the Fed's annual "stress tests" released Thursday, some of the country's biggest banks, such as J.P. Morgan Chase & Co. and Citigroup Inc., fared particularly well, with their capital ratios -- a key measure of financial strength -- increasing briskly from levels seen during last year's drill and comfortably exceeding the level that the regulator views as a minimum.

A senior Fed official, in a conference call with reporters, noted the broad improvement banks had made in recent years, saying they entered this year's exam with more capital and higher-quality loans. They also benefited as the heavy legal costs from their role in the financial crisis recede.

Next week, the Fed will release the second part of the tests, which include regulators' decisions on whether to allow or block banks' plans to return capital to shareholders through dividends or share buybacks.

Thursday's results don't necessarily predict the Fed's verdict next week, since in the second round the Fed judges banks not just by their balance sheets, but by how officials assess banks' risk-management practices.

Overall, the Fed calculated that 33 of the largest U.S. banks would have loan losses of $385 billion under a hypothetical scenario that envisions the U.S. unemployment rate more than doubling to 10%, the stock market losing half its value and financial markets becoming so topsy-turvy that short-term U.S. Treasury rates turn negative as investors pay the U.S. government to hold their money. Even with those big losses, they would still have enough capital to satisfy regulators, the Fed said.

This year's exams were "arguably the most stressful stress tests yet," said Moody's Analytics Chief Economist Mark Zandi in a statement.

Big bank shares added to their gains of the day in after-hours trading after the results were released, with shares of the biggest six U.S. banks -- J.P. Morgan, Bank of America Corp., Citigroup, Wells Fargo & Co., Goldman Sachs Group Inc. and Morgan Stanley -- rising between 0.3% and 2.2%.

The stress tests were created during the financial crisis and helped in 2009 to convince panicky investors that big banks weren't on the brink of collapse. Congress in the 2010 Dodd-Frank financial overhaul law made annual stress tests mandatory, and the Fed has adopted its own rules tying shareholder dividends to the tests.

The goal is to force banks to manage their finances in a way that they would be able to keep lending during the worst economic conditions and to diminish the risk of big bank failures.

The stress tests are just one of several new drills that regulators have been running with banks to prevent a new crisis.

They also have to file annual "living wills" which show how -- if all of those other defenses collapse and the banks find themselves on the brink of bankruptcy -- they could be unwound without an infusion of taxpayer funds or without traumatizing the broader financial system.

Despite Thursday's results, Fed officials say they are going to force the very largest banks to maintain even more capital, in part because stress tests won't necessarily anticipate the source of the next crisis.

Critics say the Fed programs are overkill, going to extremes to prevent a crisis while hampering the economy's ability to recover from the last one.

"I think the Fed is trying to make these entities fail-proof; I think it's kind of spilling over the entire financial community," Rep. Randy Neugebauer (R., Texas) told Fed Chairwoman Janet Yellen during a congressional hearing Wednesday. "We've got economists trying to run banks," he added, blaming that for "anemic growth."

The stress tests "will make you very safe," Bank of America Corp. CEO Brian Moynihan told a Wall Street Journal conference last week. "The question is whether it restricts lending."

Fed defenders say the tests have made banks stronger, and stronger banks make more loans than weaker ones.

This is the second year in a row in which all the banks taking the tests maintained capital levels above what the Fed views as a minimum allowance. The Fed said the banks collectively maintained at least 8.4% high-quality capital as a share of assets, staying well above the Fed's 4.5% minimum even after being pounded by a severe economic downturn. That was also better than the 7.6% in high-quality capital they maintained in last year's test. The banks collectively started this round of tests with 12.3% capital at the end of 2015.

The Fed says banks have more than doubled their capital since 2009, boosting common equity by more than $700 billion.

The Fed changes the details of its recession scenarios from year to year, so the specifics can hit one type of bank harder than another. Relative to last year, this year's negative-rate scenario took a tougher toll on traditional banking businesses that rely on deposits as a source of funding, the senior Fed official said. That was a contrast from last year, when large trading banks were harder hit than in the past because the Fed in that scenario assumed significant corporate defaults. The low-rates scenario also helped to boost trading revenue for the biggest banks by limiting stock-price declines and market volatility, the Fed official said.

This led all six of the biggest U.S. banks to show higher predicted net revenue before credit losses in the test. J.P. Morgan's predicted revenue more than doubled compared with last year's exam, and that of Goldman Sachs quintupled. That, along with a higher starting point for their capital bases, helped all six post minimum capital levels in the test that were higher than those registered in last year's exams.

In addition to running the stress tests on their current balance sheets, the banks have also submitted to the Fed their desired plans to return capital to investors, making the case that they could pass the test even after making those payouts.

If the firms determine, based on Thursday's results, that their capital plans would push them below the Fed's minimum required threshold, they have until Saturday to take a one-time shot at a "mulligan" -- cutting their request for dividends or buybacks to stay above the Fed's minimum requirement.

--Christina Rexrode and Emily Glazer contributed to this article.

Write to Ryan Tracy at ryan.tracy@wsj.com and Donna Borak at donna.borak@wsj.com

(END) Dow Jones Newswires

June 24, 2016 02:47 ET (06:47 GMT)

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