Positive Stress Test Results: Victory for Banks? - Analyst Blog

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On Thursday, the Federal Reserve released the Dodd-Frank Act supervisory stress test 2015 (DFAST 2015) results, which to a great extent reflect the stability in the banking system. In fact, this reaffirms that the U.S. banking giants are adequately capitalized to survive under a tremendously difficult economic scenario.

All bank holding companies (BHCs), including certain U.S. units of foreign banks with $50 billion or more in total consolidated assets, are part of DFAST 2015. Among 31 BHCs that submitted their capital plans to the Fed in Jan 2015, UT-based Zions Bancorp ZION and New York-based The Goldman Sachs Group, Inc. GS have their certain ratios near the minimum requirements by the Fed.

This may create an obstacle in getting approval for their capital plans, which is expected to be announced next week for all banks. Further, these 31 banks altogether account for approximately 80% of total banking assets in the country.

Nevertheless, the clearance of the stress test does not automatically lead to the conclusion that the banks qualify for additional capital deployment. The banks will have to wait til Mar 11 for approval of their capital plans.

Root of the Stress Test

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 collapse. Such a situation compelled the U.S. government to infuse billions of dollars into credit markets and save the entire financial system from failing.

Stress tests have been annually conducted since 2009. The environment of the last 5 rounds of stress tests along with the latest one is quite dissimilar to the Fed's first round. The first round, conducted when the country was teetering under tremendous recessionary pressure, was aimed at estimating how much the banks would lose if the economic downturn proved deeper than expected. Since then, the stress test rounds are precautionary measures amid an economic recovery.

The Federal Reserve's latest stress test scenario projections include input data supplied by the 31 banks participating in DFAST 2015 and models created by the regulatory staff and evaluated by a group of Fed economists and analysts. These models were developed with the intention to inculcate the impact of the macroeconomic and financial market factors that are included in the Supervisory Stress Scenario and distinctive factors of the banks' loans and securities portfolios, trading as well as other factors affecting losses, revenue and expenses.

Moreover, the Fed's stress test was conducted to find out whether the banks have enough capital to survive another financial crisis, including a hypothetically 10% unemployment rate, more than 60% fall in stock prices, more than 25% drop in housing prices along with an economic downturn in developing Asia.

Moreover, severe recession in the U.K., Europe and Japan was featured along with expected losses of $490 billion at the 31 bank holding companies during the 9 quarters of the theoretical stress scenario. Further, tier 1 common capital ratio was anticipated to fall from an actual 11.9% in the third quarter of 2014 to 8.2% in the hypothetical stress scenario. The requirements in the sixth round of stress test was tougher compared with the prior ones.

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.

Successful Banks

Among 31 participating banks in the stress test, smaller banks compared to Wall Street biggies like Morgan Stanley MS , JPMorgan Chase & Co. JPM and Goldman performed well. With 13.9% capital ratio, Discover Financial Services DFS was among the best performing banks.

Notably, though Citigroup Inc. C satisfied the stress test requirements last year, the Fed objected to its plan to deploy capital to shareholders based on certain "qualitative" reasons, recorded tier 1 common capital ratio 8.2%.

Among other major banks, Bank of America Corp. BAC and Wells Fargo & Co. WFC with 7.1% and 7.5% capital ratios, respectively, fared well compared with the prior-year test.

Further, JPMorgan held a steady capital ratio of 6.5%. However, two major banks - Zions and Morgan Stanley recorded 5.1% and 6.2%, the lowest results above the minimum requirement of 5%.

Recovery on the Way

This is not the final round. The big banks will have to undergo the Fed's stress test once every year. This would help build up the weak capital levels of banks, which are always a threat to the economy. Also, this could ultimately translate to less involvement of the taxpayers' money for bailing out troubled financial institutions.

However, the government must necessarily set some 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.

Yet, the banking sector presented a slightly improved picture in 2014 compared to 2013. 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. Thus, it can be said the economy is on the right track to recovery.

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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.

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

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