The Fed’s Stress Test: Summary, Results And Implications

The country’s banking sector came out with a much better report card after the Federal Reserve’s stress test this time around with the number of bank holding companies (BHCs) failing the test dropping from four last year to just one. While Citigroup (NYSE:C) and SunTrust Bank (NYSE:STI) managed to redeem themselves by shoring up capital over the year, Metlife (NYSE:MET) excused itself from the test by deregistering as a BHC – leaving Ally Financial with the dubious distinction of being the repeat offender which was the only one to fail among the 18 largest U.S. BHCs.

As we pointed out in our article “The Fed’s Stress Test: Here’s Why It Matters,” the test allows investors to understand the strength of a particular bank’s business model and capital structure by subjecting it to a rigorous ‘what-if’ scenario. And as all the banks underwent the same evaluation process, investors received an invaluable piece of data – how one bank stacks up against another when it comes to being sufficiently capitalized to face an adverse economic environment.

For the banks that passed the stress test, the results are a green signal to their plans to return more cash to investors – through dividend rate hikes, share repurchase programs, or both. With the banks expected to begin announcing the capital return plans they submitted to the Fed starting next week, all eyes are on Citigroup, which was put in an embarrassing situation last year when the Fed rejected its capital plan, and Bank of America (NYSE:BAC), which has only been paying a token dividend since the economic downturn of 2008.

See Full Analysis for: Citigroup | Bank of America

The key takeaway from the Fed’s stress test is the table below, which shows the minimum capital ratios the regulator estimated for each of the 18 banking institutions at the end of the test period in Q4 2014. ^[1] These figures incorporate any corporate actions the banks proposed to undertake before then – including dividends, share repurchases and major acquisitions/divestitures.

The cut-off levels for each of the capital ratios are:

• Tier 1 Common: 5%
• Tier 1 Capital: 4%
• Total Risk-Based Capital: 8%
• Tier 1 Leverage: 3% for all except Ally, American Express and Capital One in each of which case it is 4%

From the table, it is clear why Ally failed the tests. Its minimum Tier-1 capital at the end of 2014 under the adverse conditions assumed would end up at a dismal 1.5% – well below the 5% requirement. Notably, the banks that have the lowest Tier 1 common ratio among the 17 that passed the tests are the two investment banking giants Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) followed by three of the country’s four biggest banks – JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC). The fact that Citigroup is much more comfortably placed in the table than its mega-sized peers points to a commendable effort by the country’s biggest bank to strengthen its capital structure considerably in 2012.

Nevertheless, all the BHCs besides Ally can go ahead with their proposed capital plans as the tests conclude that even if they distribute a higher amount of capital back to shareholders in coming quarters, they would still be able to maintain their capital levels above mandatory requirements. These requirements are on par with the stringent levels suggested by the Dodd-Frank Act.

This is the second article in our series on the Fed’s Stress Test, and its implications for the public at large. In subsequent articles we will detail the results of the test for individual banks.

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1. Methodology and Results for Stress Scenario Projections (PDF), Federal Reserve Website [↩]