By Ryan Tracy, Eyk Henning and Emily Glazer
Two large European banks, Deutsche Bank AG and Banco Santander
SA, are expected to fail the Federal Reserve's stress test over
shortcomings in how they measure and predict potential losses and
risks, according to people familiar with the matter.
A rebuke would mark the second year large foreign banks, which
were drawn into the Fed's stress tests in 2014, failed to meet the
U.S. regulator's expectations for risk management. As banks have
bulked up capital cushions to ensure they can withstand losses in
periods of turmoil, the Fed has focused on more qualitative issues,
including whether banks accurately measure potential losses in
credit portfolios and correctly collect risk-exposure data. The Fed
also seeks to determine whether they have strong internal
controls.
Failing the stress tests would likely subject the U.S. units of
Deutsche Bank and Banco Santander to restrictions on paying
dividends to their European parent companies or other shareholders.
Santander, the largest eurozone bank by market capitalization, is
already under such a restriction after failing its first stress
test last year. Deutsche Bank, the biggest German bank by assets,
is undergoing the U.S. stress-test process for the first time this
year.
Both Deutsche Bank and Santander passed European Central Bank
stress tests in October. Those tests focused on whether the banks
had enough capital to withstand a two-year recession but didn't
assess such things as governance, risk management and other more
subjective factors like the Fed's test.
The expected Fed action comes amid a tussle between the U.S.
regulator and foreign banks over what the Fed views as potential
vulnerabilities at overseas firms with large U.S. operations. The
Fed wants European banks to adhere to stricter rules and fix flaws
that could potentially destabilize a firm to the point it needs
support from the U.S. central bank, as happened during the 2008
financial crisis.
The Fed's board of governors will disclose partial results of
the test on March 5 and full results on March 11, including any
capital restrictions.
Last year, the board met just ahead of releasing the results to
vote on whether banks should fail the tests for qualitative
reasons. It ultimately rejected Citigroup Inc. as well as U.S.
units of Santander, HSBC Holdings PLC and Royal Bank of Scotland
Group PLC on such grounds. At the time, it cited the foreign banks
for "significant deficiencies" in their capital-planning
process.
The Fed on Friday declined to comment on specific banks.
Deutsche's U.S. unit, Deutsche Bank Trust Corp., is expected to
be found adequately capitalized by the Fed but will likely receive
a warning on qualitative shortcomings, according to people familiar
with the matter. A bank spokeswoman said Deutsche Bank Trust
represents less than 5% of the parent's total assets.
Deutsche Bank is in the process of fixing flaws the Fed has
identified in areas ranging from its regulatory reporting, risk
control, monitoring and compliance systems, these people said. The
bank has also been reprimanded by the Fed for flaws in its
regulatory reporting, The Wall Street Journal reported last
year.
In a letter to Deutsche Bank executives in December reviewed by
the Journal, a senior official with the Federal Reserve Bank of New
York said reports produced by some of the bank's U.S. arms "are of
low quality, inaccurate and unreliable. The size and breadth of
errors strongly suggest that the firm's entire U.S. regulatory
reporting structure requires wide-ranging remedial action."
At the time of the report, a Deutsche Bank spokesman said the
German bank had "been working diligently to further strengthen our
systems and controls and are committed to being best in class" and
said the bank was spending EUR1 billion ($1.14 billion) globally
and appointing about 500 compliance, risk and technology employees
in the U.S.
A rejection by the Fed could put additional pressure on the
company's top executives, who are under scrutiny for other
problems, including regulatory reporting woes and a U.S. probe into
manipulation of the foreign-exchange market that has ensnared the
bank and many others.
A New York state regulator is installing a monitor at Deutsche
Bank in connection with that probe, the Journal has reported. A
Deutsche Bank spokesman has said in the past that it is cooperating
with investigators.
A person familiar with the matter said Santander is also likely
to fail for qualitative reasons. A Santander spokesman declined to
comment on Friday.
Santander has been working to fix the issues cited last year,
but suffered a setback in September when the Fed said the bank had
paid an unauthorized dividend, violating restrictions placed on the
firm after its failure on the 2014 stress test.
The Fed forced Santander's parent company to reimburse the U.S.
unit for the dividend, barred it from additional payouts and
required it to beef up internal controls. At the time, Santander
declined to comment. Ana Patricia BotÃn, the Spanish firm's new
executive chairman, has vowed to improve the bank's regulatory
compliance.
Quantifying the impact of a restriction on dividend payments can
be difficult, because banks don't always disclose the amount they
ask the Fed for permission to pay. In a note to clients Wednesday,
analysts at RBC Capital Markets estimated 24 banks taking the test
would be able to pay an average of 74% of their earnings, with a
range of between 17% and 100%. The analysis didn't make estimates
for Deutsche Bank and Santander.
Santander's U.S. holding company reported net income of $2.3
billion in 2014, while Deutsche Bank's reported $338 million,
according to regulatory filings.
Last year, the Fed adopted a rule forcing Deutsche Bank,
Santander and other foreign banks operating in the U.S. to form
U.S.-based holding companies that adhere to strict risk-management
standards and add potentially billions of dollars more in capital
to meet minimum requirements at the U.S. units.
For banks, managing the stress-test process is costly. A person
at one bank subject to the test said the firm has invested upward
of $50 million on personnel and systems in the past year alone in
an effort to improve the quality of its data gathering and computer
models, among other related expenses.
"You don't fundamentally understand the level of effort required
until you are in the program," this person said.
Write to Ryan Tracy at ryan.tracy@wsj.com, Eyk Henning at
eyk.henning@wsj.com and Emily Glazer at emily.glazer@wsj.com
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