Dividend Hikes, Share Repurchases To Follow Strong Performance Of U.S. Banks In Round One Of Fed’s Stress Test

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The 35 largest financial institutions in the U.S. recently sailed through the first phase of the Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR) – setting the stage for the banks to reveal their capital plans for this year late next week. This was not a surprise, as no bank has had trouble with the quantitative phase of the tests since 2014 thanks to the massive buildup of equity capital across the industry to comply with stringent capital requirements.

The eighth iteration of the Fed’s annual stress test originally involved 38 financial institutions, but the partial rollback of the Dodd-Frank Act last month exempted CIT Group, Comerica and Zions Bancorporation from the annual requirement (as each of them have less than $100 billion in assets). That said, the 35 companies that were a part of this years stress tests 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 – modifying some economic conditions under its “adverse” as well as “severely adverse” scenarios, as has been its policy over the years. We simplify the key points to put these tests in perspective below. We also summarize the results in our interactive dashboard for participating banks, parts of which are captured below.

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 Fed’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.

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 is that if the financial institutions can hold their ground under such extreme circumstances, they will be well-positioned to withstand an adverse, but more likely scenario in the future.

A Quick Look At The Performance Of Each 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 35 institutions tested under the severely adverse scenario. Notably, the combined CET1 capital ratio for the 35 participating companies was 12.3% for Q4 2017, with the figure falling to a minimum of 7.9% under the severely adverse scenario under the stress test.

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 ratios for the U.S.-based Global Systemically Important Financial Institutions (G-SIFIs) from their current figures to their minimum levels as determined by the test for a “severely adverse” situation.

It should be noted that the minimum CET1 capital ratio figure for an individual bank needs to remain above the 5% cut-off to pass the stress test. From the chart above, it is evident that the minimum CET1 ratio for State Street (5.3%) and Goldman Sachs (5.6%) came close to the 5% level under the severely adverse scenario. This is likely to weigh on their capital return plans for this year.

Some other key observations from the stress tests:

  • U.S. subsidiaries of all foreign banking giants have fared exceptionally well in the stress test. This is primarily because the U.S.-based subsidiaries generally represent a small, lower-risk part of the more diversified business models of these banks.
  • Among the U.S. banks, custody banks BNY Mellon and Northern Trust figure among the best-capitalized firms in the list, and are also the ones least affected by the test scenario.
  • Trading-focused banking giants Morgan Stanley and Goldman Sachs witness the sharpest declines in minimum CET1 common ratios, as the test scenario shaves off more than six percentage points from the benchmarks for each of these banks.

What Do These Results 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 or divestitures – a bank with a minimum capital ratio figure comfortably above 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 for qualitative reasons. While an increase in dividends and modest share buybacks are likely in the cards for most of the big banks, we expect Morgan Stanley and Bank of America to declare a sizable increase in payouts, while Goldman and State Street investors may potentially see lower payouts over the next twelve months.

You can compare changes in CET1 ratios for these banks under the severely adverse as well as adverse scenarios in more detail on our interactive dashboard.

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