New Obstacle for U.S. Banks' Stress Test - Analyst Blog


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With few months to go before the announcement of annual Comprehensive Capital Analysis and Review (CCAR) results for 2014, U.S. banks now have a new obstacle. On Monday, the Federal Reserve announced the independent projection of bank holding companies' balance sheets and risk-weighted assets under the supervisory scenarios by the agency itself. However, previous annual reviews were based on the projections provided by each individual bank.

These balance sheet projections are used for computation of pro-forma regulatory capital ratios under different scenarios. According to the Fed, independent balance sheet projections provide reliable horizontal analysis of banks. Moreover, it enhances the comparison of results across all bank holding companies and sustains the integrity of results as well.

After clearing stress tests, the banks have the privilege to increase dividends and buy back shares. It is intimated to these banks that payment of higher dividends will be restricted if they fail to meet the requirement of 5% ratio of core capital to risk-weighted assets, among other criteria.

For calculation of capital ratios, a measure of shareholder equity is divided by risk-weighted assets. Therefore, with an increase in asset balances (all other components being equal) banks would be required to hold more capital to keep ratios constant.

Currently authorized under the Dodd-Frank financial services law, the stress tests were first introduced after the 2008 financial crisis. During this economic downturn, major financial institutions like Lehman Brothers collapsed and several other big banks were on the brink of failure. Such a situation compelled the U.S. government to infuse billions of dollars into credit markets and save the financial system.

The Fed's latest stress test scenario projections include input data supplied by the 18 banks participating in DFAST 2013 and models created by the regulatory staff and evaluated by a group of Fed economists and analysts. These models were developed taking into consideration the impact of macroeconomic and financial market factors, which were included in the Supervisory Stress Scenario. The banks' loans and securities portfolios, trading as well as other causes affecting losses, revenues and expenses were taken into count as well.

Further, as per the Dodd-Frank Act, bank holding companies participating in the Fed's stress test rules have to conduct two company-run stress tests each year. Moreover, they have to publicly unveil a summary of the results of the company-run stress tests conducted under the strictly adverse scenario given by the Fed.

Therefore, in September, several U.S. banking majors released their mid-year stress test results as required. The results reflected stability in the banking sector to a great extent. Also, these reaffirmed the ability of U.S. banking giants to survive another economic meltdown.

Notably, the mid-year stress test is different from the annual CCAR process conducted by the Federal Reserve. This mid-cycle stress test was performed under a hypothetical severely adverse economic scenario assumed by the individual banks.

Wells Fargo & Company ( WFC ), JPMorgan Chase & Co. ( JPM ), Bank of America Corporation ( BAC ), Citigroup Inc. ( C ) and The Goldman Sachs Group, Inc. (GS) were among the major banks that released results, which stated that minimum capital levels would remain well above regulatory requirements during the nine-month horizon (from second-quarter 2013 through second-quarter 2015) of high unemployment, declining home prices and stock-market uncertainty.

U.S. banks are showing signs of improvement despite being compelled to meet strict regulatory standards. Though it is too early to be confident of the sector's growth prospects, the progress seen in the first nine months of 2013 indicates a brighter future for banks that are less dependent on risky activities and resort to other profit-making ways.

Improved economic data such as higher consumer spending and GDP, a rebounding housing market and declining unemployment rate raise our hopes. However, the still low-rate environment remains a challenge going forward.

It is impressive to see that U.S. banks are taking legal and regulatory pressure in their stride, indicating their ability to overcome future challenges. However, with the economy still looking to gain traction, we do not expect the sector to return to its pre-recession peak any time soon.

BANK OF AMER CP (BAC): Free Stock Analysis Report

CITIGROUP INC (C): Free Stock Analysis Report

JPMORGAN CHASE (JPM): Free Stock Analysis Report

WELLS FARGO-NEW (WFC): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Business , Stocks
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