A Look At Results and Implications Of The Fed’s 2016 Stress Test For Banks

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The 33 largest financial institutions in the U.S. had no trouble in clearing the first phase of the Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR) for banks – the results of which were announced by the regulator on Thursday, June 23. ((Federal Reserve releases results of supervisory bank stress tests, Federal Reserve Press Releases, Jun 23 2016)) The financial industry underwent the sixth iteration of the Fed’s stress tests this time around, with the 33 firms involved representing more than 80% of the total banking assets in the U.S. The first phase aims to ensure that each participating firm is sufficiently capitalized to withstand a severely adverse economic scenario, and the positive results point to a notable improvement in strength for the U.S. banking sector over recent years.

The Federal Reserve tweaked a few aspects of its stress test this year compared to the previous one. To begin with, the number of bank holding companies (BHCs) tested increased from 31 last year to 33 with the addition of BancWest and TD Group for the first time. The Federal Reserve also expanded on the “severely adverse scenarios” which it introduced as a part of the stress tests last year by adding the possibility of negative yields for short-term Treasury securities.

Below we simplify the key points to put these tests in perspective and also summarize the results to help understand how the firms fare with respect to each other.

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Understanding The Test Scenario

Since it was first conducted in 2009, the Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR) for banks has been tracked closely by banks, lawmakers, investors and the public at large. This is because the review process – and specifically the stress test conducted as a part of it – is an important tool in the financial regulator’s arsenal to ensure that the country’s financial system can withstand an extreme adverse economic scenario in the future. As these tests aim to gauge the strength of each of the country’s largest financial institutions under conditions similar to those seen during the economic downturn of 2008, they help the Fed advise individual firms about how much they need to shore up their balance sheets if necessary.

The purpose of the stress test is to ensure that the banks have enough capital to lend to customers and businesses even under extremely trying economic conditions. The test scenario includes 28 variables that capture various aspects of the global economy. [1] Of these, 16 variables relate to the domestic economy and the rest are international variables.

The table below summarizes the main domestic variables considered by the Federal Reserve for the stress test. The most recent value of each of these variables is shown alongside the worst-case figure for each of them under the “adverse” as well as the “severely adverse” scenarios.

Variable Most Recent Value Adverse Scenario Severely Adverse Scenario
U.S. Unemployment Rate 4.7% (May 2016) 7.5% 10%
Real GDP Growth Rate 0.8% (Q1 2016) -3% -7.5%
National House Price Index 176.91 (Mar 2016) 155 130
Dow Jones Total Stock Market Index 21,800+ (Jun 2016) 15,000 10,000
U.S. Market Volatility Index (VIX) 15 (May 2016) 40 70

The 12 international variables capture the impact of a fall in real GDP growth, inflation, and the U.S./foreign currency exchange rate for the Eurozone, the United Kingdom, developing Asia and Japan.

The underlying idea that emerges on seeing these variables and their values is that if the financial institutions can hold their ground in such an extreme scenario, they will be well-positioned to withstand an adverse, but more probable scenario in the future.

How Did Each Financial Institution Do?

The key takeaway from the Fed’s stress test is the impact on Tier 1 common ratios for each of the 33 institutions tested under the severely adverse scenario. No doubt, each of the firms will see this benchmark figure fall from current actual values under the test conditions, but the amount it actually falls is governed by a firm’s business model, loan portfolio as well as the type of assets on its balance sheet. The table below represents the change in the Tier 1 common ratio for these firms from their current figure (the upper point on each line) to their minimum level (the lower point) as determined by the test for a “severely adverse” situation.

StressTest2016

The highlighted data point represents the combined performance of all the 33 participating firms. The red vertical line is at 4.5% – the cut-off required for a firm to pass the stress test. With the Tier 1 capital ratio for all banks remaining above this figure even under the worst-case scenario, all of them cleared the quantitative round of the Fed’s stress test. Notably, Deutsche Bank’s results stand out in comparison to all other BHCs tested, thanks largely to the fact that the U.S-based subsidiary that was tested represents only a small, low-risk part of the German banking giant’s diversified banking operations in the U.S. On the other hand, regional banking player Huntington saw its capital ratio shrink to 5% under the severely adverse scenario – something that will weigh on its capital return plans for the year.

There are some other interesting things to note here. Custody banks BNY Mellon (NYSE:BK) and Northern Trust, card-focused lenders Discover (NYSE:DFS) and American Express (NYSE:AXP), and Santander Bank (North America) figure among the best-capitalized firms in the list, and are also the ones least affected by the test scenario. On the other hand, trading-focused banking giants Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS), and geographically-diversified groups HSBC (NYSE:HSBC) and Citigroup (NYSE:C) are seen at the bottom of the list in terms of worst minimum Tier 1 common ratios as the test scenario shaves off more than five percentage points from the benchmark for each of these banks.

What Does This Mean For These Banks In The Near Future?

The most immediate impact of the announced stress test results for the banks will be on their capital plans for the year. As the second part of the stress test incorporates any corporate actions the banks proposed to undertake over the next four quarters – including dividends, share repurchases and major acquisitions/divestitures – a bank with a minimum capital ratio figure comfortably above 4.5% in the severely adverse scenario should have more leeway with its capital plan.

There is an important exception to this, though, as the the Fed can still reject a bank’s capital plan due to qualitative factors brought to its notice like it did in the case of Citigroup in 2014. While an increase in dividends and modest share buybacks are likely in the cards for most of the big banks, investors will be most interested in the capital return plans Bank of America, Citigroup and Morgan Stanley are expected to release next week, as these three banks have returned the least cash to investors since the economic downturn.

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Notes:
  1. Dodd-Frank Act Stress Test 2016: Supervisory Stress Test Methodology and Results , Federal Reserve Website []