After the release of the Dodd-Frank Act supervisory stress
test 2014 (DFAST 2014) results last week, the Federal Reserve
approved the capital plans of 25 financial institutions out of 30
in the Comprehensive Capital Analysis and Review (CCAR). The
capital plans of the remaining 5 have been rejected.
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The Fed's nod to most of the major U.S. banks reflects stability
in the banking system to a great extent. All the bank holding
companies (BHCs) with $50 billion or more in total consolidated
assets are part of DFAST 2014. Notably, 30 BHCs that submitted
their capital plans to the Fed in Jan 2014 account for
approximately 80% of total banking assets in the country.
The banks now have the privilege to increase dividends and buy
back shares. Amid concerns that banks might not have sufficient
capital to counter another financial crisis, these were asked to
submit their capital plans to the Fed. The banks were intimated
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 requirements.
Root of the Capital Rules
Currently authorized under the Dodd-Frank financial-services law,
the stress tests were first introduced after the 2008 financial
crisis. During this economic downturn, big financial institutions
like Lehman Brothers collapsed and several other big banks were
on the verge of a meltdown. This compelled the U.S. government to
infuse billions of dollars into credit markets and save the
entire financial system from crumbling.
Stress tests have been annually conducted since 2009. The
environment of the last 4 rounds of stress tests, along with the
latest one, is quite different from the Fed's first round. The
first round, conducted when the country was under tremendous
recessionary pressure, was aimed at estimating how much the banks
would lose if the economic downturn proved worse than expected.
Since then, the stress test rounds are precautionary measures
amid a recovering economy.
The Fed's latest stress test had three scenarios - baseline
(based on expectations of private economists), adverse and
severely adverse - to test the banks' capital strength under
stressful situations. These included 26 different variables such
as employment and exchange rates, the anticipated changes in GDP,
economic activity, prices, interest rates and a substantial
weakness in emerging economies.
Further, the Fed tested the banks' balance sheet under the impact
of slowdown across economies and severe recession in the U.S.,
Europe and Japan, leading to about 50% fall in equity prices.
Other stressful circumstances comprised unemployment rate
reaching 11.25%, home prices declining nearly 25% and the U.S.
GDP decreasing 4.75%.
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, these 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.
Wells Fargo & Company
JPMorgan Chase & Co.
The Bank of New York Mellon Corporation
Capital One Financial Corporation
State Street Corporation
) are among major banks that have received clearance from the Fed
to raise their dividends or repurchase shares.
However, among other major banks,
Bank of America Corporation
The Goldman Sachs Group Inc.
) resubmitted their capital plans which got approval. The
resubmission was led by the first round stress test results last
week, which reflected high debt to equity ratio in their original
Banks on Shaky Ground
Among 30 bank holding companies which submitted their capital
plan to the Fed in Jan 2014, UT-based lender,
) was the only bank that failed to meet the minimum requirement
of 5% Tier 1 common capital ratio. Therefore, with 3.5% capital
ratio, Zions remains unstable, with substantial commercial real
estate losses, higher risk-weighted assets as well as lower
pre-tax, pre-provision net revenue and received Fed's rejection
of its capital plan.
Apart from Zions, the capital plan of
) along with the plans of U.S. units of London-based
HSBC Holdings plc
The Royal Bank of Scotland Group plc
) and Spain's
Banco Santander, S.A.
) have been rejected by the Fed based on certain "qualitative"
reasons. The Fed holds the opinion that these banks have
loopholes in their risk management practices under stressful
Moreover, flaws in their capital distribution plans have been
observed. Therefore, these banks will be required to resubmit the
capital plan. However, these banks are allowed to continue with
their existing capital deployment plans.
Recovery on the Way
This, however, is not the end. The major banks will have to
undergo the Fed's stress test once every year. These would help
build up the weak capital levels of banks, which are a looming
threat to the economy. Also, this could ultimately translate to
less involvement of the taxpayers' money for bailing out troubled
However, the government must necessarily frame certain policies
so that every industry participant contributes to the overall
profitability. While the bigger banks benefited greatly from the
various programs launched by the government, many smaller banks
are trying hard to catch up.
The banking sector presented an improved picture in 2013 compared
to 2012 and 2011. Nagging issues like depressed home prices, loan
defaults and unemployment levels are not so prominent compared to
the last few years.
Though economic uncertainty still lingers, banks are actively
responding to every legal and regulatory pressure. In fact, this
has positioned the banks well to encounter impending challenges.
As the sector is undergoing a radical structural change, it is
expected to witness headwinds in the near to mid term. However,
entering the new capital regime will significantly improve the
industry's long-term stability and security.
Nevertheless, the approval from the Federal Reserve to increase
dividend payment and accelerate the share buyback program will
definitely help banks attract more investments going forward.
Hence, it can be said the economy is on the track to