WASHINGTON—The largest U.S. banks got permission from regulators to return profits to investors, but the U.S. banking units of Deutsche Bank AG and Banco Santander SA were held back again as the Federal Reserve released the final results of its 2016 "stress tests."

Big firms such as Bank of America Corp. and Citigroup Inc., which have struggled on the tests in past years, passed this year, as the Fed issued a broadly positive verdict on the U.S. banking sector. The prospects of greater dividends and share buybacks is good news for bank investors, who have seen financial shares battered by crimped profits and last week's Brexit vote.

This is the second set of results released by the Fed in the past two weeks, assessing whether officials believe the biggest banks could continue to lend even during a deep recession. Last week, the largest U.S. banks breezed through the first round of tests with capital ratios well in excess of the amount the regulator views as a minimum, even when put through a hypothetical recession. The tests were created after the financial crisis.

In the second round, released Wednesday, all but two of the 33 large U.S. banks taking the tests won the Fed's endorsement of their risk-management chops and its go-ahead to increase dividends or share buybacks.

Morgan Stanley was among the banks that won approval for its capital returns, but it also received a rebuke: The Fed's approval is conditional, based on "weaknesses" the regulator found in the bank's internal process. The bank must submit a revised plan addressing its shortcomings by Dec. 29. If the Fed isn't satisfied with the bank's progress, it can freeze the capital distributions.

M&T Bank Corp. gained the Fed's approval, but the Buffalo, N.Y.-based firm passed only after scaling back its proposal to distribute funds to shareholders, in order to ensure its capital buffers stayed above the minimums required by the Fed.

It was the only bank to take the so-called mulligan allowing banks to adjust their payout plans. Had the bank not done so, it would have failed the test by falling below two of the four required capital ratios in a hypothetical recession, the Fed said.

Overall, the Fed results should cheer bank investors after a rough few months. Shares in financial firms were hit hard by last week's vote by Britain to exit the European Union and as long-term interest rates have plummeted, threatening bank profitability.

While Brexit didn't play a direct role in the tests, the exams had included the prospect of severe recessions in the U.K., the European Union and the U.S.

Banks that received approval for their capital plans will be able to pay out as much as around two-thirds of projected net income for the coming four quarters, a senior Fed official said. That also means, though, that banks will continue to retain capital, which could also reassure investors worried about their ability to withstand any continuing Brexit-related market tumult.

The central bank rejected outright the capital plans of the U.S. banks owned by Germany's Deutsche Bank and Spain's Santander, as it did last year. The Fed cited improvements but said there was still "insufficient progress" by the firms in correcting flaws and meeting supervisors expectations.

Both firms have been under significant regulatory scrutiny after being faulted for their shortcomings in predicting risk on the stress tests, as well as in other areas. Santander's U.S. bank is the first to fail the test three years in a row, and Deutsche Bank's subsidiary has now failed two years running.

Overall, the verdict reflects the Fed's view that the banking sector is much stronger than it was leading up to the 2008 bailouts. Bank regulators have steadily raised capital requirements for the largest banks since the crisis in an effort to make banks—and the financial system—more resilient and better able to absorb losses. The changes have forced banks to fund themselves with less borrowed money and more investor funds, such as common equity that can't flee when market turmoil strikes.

In the six years since the tests were first put in place, "the participating firms have strengthened their capital positions and improved their risk-management capacities," Fed governor Daniel Tarullo, the official overseeing the tests, said in a statement. "Continued progress in both areas will further enhance the resiliency of the nation's largest banks."

The stress tests, which test capital levels by putting banks through a hypothetical shock, were created during the financial crisis and helped end the panic in 2009 by showing investors big banks were stable. Congress made them mandatory in 2010, and the Fed in 2011 tied passing the test to approval to pay shareholder dividends.

The goal is to make sure banks can keep lending during the worst economic conditions, and to diminish the risk of big bank failures. In addition to the tests, big banks also face new requirements that they use stable funding sources and craft "living wills" to show how they could go through bankruptcy without needing a bailout or causing a broader economic crisis.

U.S. banks collectively had 12.2% high-quality capital as a share of assets in the first quarter of this year, more than twice the 5.5% level in the first quarter of 2009, the Fed said.

For Deutsche Bank and Santander, the Fed's rejection of those firms' capital plans effectively locks up some U.S. profits, which can't be sent home at a higher rate until they pass the tests.

Those firms don't currently have publicly announced plans to return capital home that would be affected by that restriction, a Fed official said.

Santander executives have said during the past couple of years that the regulatory troubles in the U.S. are partially the result of growing pains as the lender builds up from scratch a holding company to oversee its banking unit and consumer-lending subsidiary. But U.S. regulators have also faulted Santander for risk-management problems broadly, and investors and analysts say they are growing impatient with Santander's mess in the U.S.

The Deutsche Bank unit in question, Deutsche Bank Trust Corp., represents about 3% of the German lender's total global assets. A bigger test for Deutsche Bank will come in two years when its bigger, newly consolidated U.S. business—set up as what's known as an intermediate holding company—comes fully under stress-test review.

Two new entrants to this year's test—BancWest Corp., a subsidiary of France's BNP Paribas SA, and TD Group U.S. Holdings LLC, which is owned by Toronto-Dominion Bank—passed the Fed's yearly exercise.

The Fed changes the details of its recession scenario from year to year, so the specifics can hit one type of bank harder than another. This year, the Fed's hypothetical scenario envisioned the U.S. unemployment rate more than doubling to 10%, the stock market losing half of 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.

Jenny Strasburg and Jeannette Neumann 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 29, 2016 16:55 ET (20:55 GMT)

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