SAN Banco Santander SA

By Ryan Tracy and Donna Borak 

Big U.S. banks won permission from regulators Wednesday to boost dividends and buybacks, offering investors some welcome news after the sector got hammered when the U.K. voted last week to exit the European Union.

All but two of 33 institutions passed the final round of the Federal Reserve's annual "stress tests," conducted to gauge how such firms would fare in a new financial crisis.

Big firms such as Bank of America Corp. and Citigroup Inc., which struggled on the tests in recent years, passed this time. Morgan Stanley also passed but received a bit of a rebuke. The Fed said it found "weaknesses" in internal risk- management processes and required the bank to submit a revised capital plan by the end of the year, though it will still be able to return capital in the meantime.

Morgan Stanley Chairman and Chief Executive James Gorman said that the firm is able to increase its capital return to shareholders for the fourth consecutive year, adding "we are committed to addressing the Fed's concerns about our capital planning process and fully expect to meet their requirements within the established time frame."

The U.S. banking units of two foreign firms, Deutsche Bank AG and Banco Santander SA, were flunked, due to Fed concerns about their ability to measure risks. It was the second year in a row the German bank failed and the third consecutive failure for the Spanish firm.

Overall, the 2016 stress tests reflect 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 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, and many analysts said those changes helped contain the damage from the Brexit market rout.

The stress-test result could prove a tonic for bank stocks, which have been wilting of late. Falls in long-term bond yields earlier this month promised to further pressure profits, and additional declines following the Brexit vote made the outlook worse. Fears of a hit to global growth after the U.K. vote, along with the prospect of market turmoil, cast an even darker cloud over banks.

Despite the firming of stocks generally in the past two days, the KBW Nasdaq Bank Index remains down 7% from its level when the Brexit vote was announced. Among S&P 500 sectors, financials are the worst performer this year, down 5.6%. The stress-test results were announced after U.S. markets closed, and Bank of America, Citigroup and J.P. Morgan Chase & Co. all followed the Fed report by announcing they would boost capital returns to shareholders. In after-hours trading, shares of Citigroup were up around 2.3%, Bank of America 1.7% and J.P. Morgan 1.4%. Despite its conditional approval on the test, shares in Morgan Stanley rose 1.2%.

This is the second set of stress-test results released by the Fed over the past week, 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.

Born of the financial meltdown in 2009, the stress tests have become a defining moment each year for big banks and investors. Bank executives manage their firms with one eye on how it will affect test results and have had to spend billions of dollars to develop systems to deal with them. They have become crucial for investors ever since the Fed decided in 2011 that the banks would have to submit capital-return plans as part of the tests and dividends and buybacks became dependent on the outcome of these hypothetical exercises. Some bankers have criticized the Fed's process as overly opaque and stringent and have complained that the higher capital required by them has choked lending and harmed the economy. That said, both bank executives and regulators have said the tests have made banks stronger and forced improvements in the ways that banks measure and manage risks.

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.

Nevertheless, a document issued by the Fed Wednesday outlined areas where the regulator expects further improvement next year, a reminder that future stress-test successes aren't guaranteed.

For Deutsche Bank and Santander, the Fed's rejection of those firms' capital plans is a public embarrassment, but the practical impact is more limited. The rejection effectively locks up some U.S. profits, which can't be sent home to the parent firms at a higher rate until they pass the tests, but the firms don't have publicly announced plans to return capital home that would be affected by that restriction, a Fed official said.

The official, on a conference call with reporters, didn't say the firms would face harsher sanctions in the future and suggested both firms are making progress. They have dedicated substantial resources and manpower to addressing regulators' concerns, but the Fed still believes the firms have substantial work to do, for example, by ensuring they have reliable data about all of the risks they face, the official said.

"We appreciate the Federal Reserve's recognition of our progress, and we will implement the lessons learned this year in order to strengthen our capital planning process," said Bill Woodley, deputy CEO of Deutsche Bank Americas.

In a statement, Santander Holdings Chief Executive Officer Scott Powell noted that the company has strong capital levels and would work to address regulators' other concerns. "We have made progress, but our internal capital planning, stress testing, internal controls, governance and oversight require further improvement to meet our regulators' expectations," Mr. Powell said. "We are financially sound. These results do not affect our ability to serve our customers," he added.

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 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 is 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.

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

It was the only bank to take the "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.

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.

--Christina Rexrode, 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 19:37 ET (23:37 GMT)

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