WASHINGTON—The largest U.S. banks have significantly bolstered
their defenses against a severe downturn since the financial crisis
and could continue lending even during a deep recession, the
Federal Reserve said it has concluded, signaling that many will win
regulators' approval next week to boost dividends to investors.
In the first part of its annual stress tests released Thursday,
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.
Still, the central bank said that despite such big losses, those
institutions meet the Fed's definition of good health—even during a
severe recession—due to a steady increase in capital on their
books, an improvement in the quality of their loans, and a drop in
costs related to crisis-era litigation.
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. In the past, banks have shown strong capital ratios in
the first part of the tests, only to be deemed as failing in the
second round, which uses a broader set of criteria. In the second
round, the Fed judges banks not just by their balance sheets, but
by how officials assess banks' risk-management practices.
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 still 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 a number of new drills that
regulators have been running with banks in an effort to prevent a
new crisis. Banks also face new requirements to hold high levels of
liquidity as well as capital, to try to prevent a short-term cash
crunch. And they 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.
"The changes we make in each year's stress scenarios allow
supervisors, investors, and the public to assess the resiliency of
the banking firms in different adverse economic circumstances," Fed
governor Daniel Tarullo said in a statement.
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. Chief Executive Brian Moynihan told a Wall Street Journal
conference last week. "The question is whether it restricts
lending."
The Fed said the 33 banks this year 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% minimum in
last year's test. The banks collectively started this round of
tests with 12.3% capital at the end of 2015.
Thursday's results mark the second straight year in which all
the banks taking the tests maintained capital levels above what the
Fed views as a minimum allowance, a result that could help persuade
the central bank to allow them to start distributing more capital
to investors than they have in the past.
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, a senior Fed official told
reporters on a conference call. 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.
Since the 2008 crisis showed banks were relying too heavily on
borrowed money, the Fed has been forcing banks to build capital,
rather than return it to shareholders. But the regulator has slowly
loosened the reins for banks that prove through the stress tests
that they are adequately managing their risks.
Shareholders of banks that have had problems with the test, such
as Bank of America Corp. and Citigroup Inc., have received paltry
dividends compared to the owners of Wells Fargo & Co. and other
firms that haven't had stress-test slip-ups.
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 in order
to stay above the Fed's minimum requirement.
The banks with ratios closest to the line this year included
Huntington Bancshares Inc. and BMO Financial Corp. Each passed one
of the ratios by less than half a percentage point.
Last year, Morgan Stanley, Goldman Sachs Group Inc., and J.P.
Morgan Chase & Co. told the Fed they wanted to scale back their
payout plans in the week between the first and second tests. All
three firms would have been judged as failing the test without
making an adjustment, but investors generally don't penalize firms
for making an adjustment after the initial results, saying they
prefer the firms to be aggressive in requesting to return
capital.
Those three firms looked stronger this year. J.P. Morgan, for
instance, had its Tier 1 leverage ratio fall only to 6.2%, compared
with 4.6% after the first round of tests last year. Goldman Sachs's
and Morgan Stanley's total risk-based capital ratio fell to a
minimum of 12.6% and 13.5%, respectively, compared with 8.1% and
8.6% last year.
Germany's Deutsche Bank AG and Spain's Banco Santander SA, whose
U.S.-based banks were the only firms to fail the tests last year,
both appeared to breeze through Thursday's results with capital
ratios far above the Fed minimums.
But last year, the two banks were tripped up because of what the
Fed called risk-management problems, rather than insufficient
capital levels. Both firms have been spending heavily on improving
their stress-testing programs and will look for redemption when the
Fed releases its round-two results next week.
Santander also failed the Fed's tests in 2014, meaning its U.S.
unit risks the ignominious distinction of being the only firm to
fail the test three years in a row.
Two other foreign-owned U.S. banks are taking the tests for the
first time this year: BancWest Corp., a subsidiary of France's BNP
Paribas SA, and TD Group US Holdings LLC, which is owned by
Toronto-Dominion Bank.
Write to Ryan Tracy at ryan.tracy@wsj.com and Donna Borak at
donna.borak@wsj.com
(END) Dow Jones Newswires
June 23, 2016 16:55 ET (20:55 GMT)
Copyright (c) 2016 Dow Jones & Company, Inc.
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