All Bank Holding Companies Breeze Through Quantitative Round Of Fed’s Stress Tests

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The seventh iteration of the Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR) for banks did not present any problems to the 34 largest financial institutions in the U.S., as all of them comfortably cleared the quantitative phase of the 2017 stress tests. This was largely expected, though, as no financial institution has faltered in the first phase of the stress tests since 2014. The first phase aims to ensure that each participating bank is sufficiently capitalized to withstand a severely adverse economic scenario, and the U.S. banking sector as a whole has strengthened considerably over recent years thanks to focused efforts by the banks as well as due to an improved operating environment. Notably, the 34 companies involved this time around represent well over 80% of the total banking assets in the U.S.

The Fed detailed the scenario to be tested this year early this February, with the testing conditions being largely similar to those adopted last year. There were a few minor changes this time though, beginning with an increase in the number of bank holding companies (BHCs) tested from 33 last year to 34 due to the addition of CIT Group for the first time. Besides this, the Fed slightly modified some economic conditions under its “adverse” as well as “severely adverse” scenarios.

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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An Overview Of 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 scenarios includes 28 variables that capture various aspects of the global economy. 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 4.3% (May 2017) 7.25% 10%
Real GDP Growth Rate 1.2% (Q1 2017) -3% -7.5%
National House Price Index 186.95 (Mar 2017) 160 135
Dow Jones Total Stock Market Index 21,400+ (Jun 2017) 14,000 12,000
U.S. Market Volatility Index (VIX) ~10 (May 2017) 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.

A Quick Look At The Performance Of Each Financial Institution

The key takeaway from the Fed’s stress test is the impact on Common Equity Tier 1 (CET1) common ratios for each of the 34 institutions tested under the severely adverse scenario. While each of the banks saw this benchmark figure fall sharply under the test conditions, the amount it actually fell for a particular bank is governed by the bank’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.

StressTest2017

The highlighted data point represents the combined performance of all the 34 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 as it has a capital ratio which is several times higher than that of its peers. This is because only 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.

There are some other interesting things to note here. Leaving out the U.S. subsidiaries of foreign banking giants (Deutsche Bank, HSBC, Santander, MUFG, TD Group), the custody banks BNY Mellon (NYSE:BK) and Northern Trust 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) witness the sharpest declines in minimum CET1 common ratios as the test scenario shaves off more than six 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, which will be disclosed along with the second and final phase of the stress test results slated to be announced next week (June 28). 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. 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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