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Major financial-sector reform legislation passed in the aftermath of the 2008 downturn, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, includes provisions requiring bank holding companies with $50 billion or more in assets, and certain large nonbank financial firms, to submit to annual stress tests by the Federal Reserve, as well as conduct stress tests of their own.

The tests aim to measure whether a bank has adequate capital to support operations during tough times. The Federal Reserve notes that capital ‘’acts as a cushion to absorb losses and helps ensure that any such losses are borne by shareholders, not taxpayers’’, as they were in 2008, under the Fed’s bank bailout program.

The tests, which have evolved in the past few years, are really two exercises. The first uses projections of the banks’ revenues, expenses, and capital ratios under three hypothetical economic scenarios (baseline, adverse, and severely adverse) to gauge a bank’s resiliency. The severely adverse scenario includes variables such as a 5% decline in real GDP, 12% unemployment, and a 50% plunge in equity prices over the test horizon.

The recently concluded stress tests also contained an evaluation of the effect of a global markets shock on the capital of six large banks with significant trading operations, including JPMorgan Chase (JPM - Free JPMorgan Stock Report).

The second part of the tests also assesses whether the banks have adequate capital to meet their obligations and operate under tough conditions and, in addition, looks at whether the banks’ plans for capital usage (for paying dividends, buying back stock, and making acquisitions) are prudent. Banks must pass this second part before going forward with their capital plans.

Results of the latest round of bank stress tests indicated that, during the tests’ nine-quarter planning  horizon (from the end of the 2012 September quarter to the end of 2014), all of the 18 bank holding companies undergoing the exercise would probably experience substantial losses (a combined $462 billion) under the test’s severely stressed scenario, and that the losses would result in substantial declines in most of the bank holding companies’ regulatory capital ratios. However, most of the banks passed the stress tests.

The so-called trust banks, that mostly provide custodial and asset management services for a fee, like Bank of New York Mellon (BK) and State Street (STT), fared relatively well. The worst performer was Ally Financial, the former General Motors Acceptance Corporation, whose projected Tier 1 common ratio, a basic measure of capital adequacy, fell from 7.3% in the 2012 September quarter, to an estimated 1.5% by the final quarter of 2014, reflecting the pending bankruptcy of its mortgage subsidiary.  Although they passed the stress tests, some of the largest banks, like Bank of America (BAC - Free Bank of America Stock Report) and JPMorgan, experienced sizable declines in their estimated Tier 1 ratios (BAC’s fell from 11.4% to 6.9%; JPM’s, from 10.4% to 6.8%) under the severely adverse scenario. 

Following the second part of the stress tests, most of the banks were allowed to go forward with their capital plans.  But the Fed objected to Ally Financial’s  capital usage strategy, reflecting its low projected Tier 1 ratio. Although the Fed allowed BB&T Corporation (BBT) to continue paying its dividend, it disagreed with other (undisclosed) aspects of its capital plan. As a result, BB&T intends to file a new plan. Meanwhile, JPMorgan Chase and Goldman Sachs (GS) were asked to submit new plans to the Fed to address “the weaknesses in their capital planning processes”, but they were allowed to continue paying dividends.

The stress tests have come under fire. Some claim the tests are backward looking, can’t accurately predict a bank’s performance under tough conditions, and create a false sense of security that might mislead bank stock investors. Others say the stress tests are too complicated, the conditions in the severely adverse scenario are improbable, and the Fed hasn’t disclosed all of the details of the exam process. Some think the tests encourage banks to ‘’manage to the model’’ rather than focus on strengthening their capital positions. 

Others believe the stress tests, while not perfect, are useful since they force banks to take a good look at their capital cushions and take corrective actions if necessary. Investors also want to pay attention to the stress test results since they determine whether a bank can increase its dividends or buy back stock. The tests also provide information regarding a bank’s financial health.

In the years ahead, the Federal Reserve no doubt will continue to refine the bank stress test process. Although the tests probably will remain controversial, we think they are here to stay, and likely to be required of banks below the $50 billion-in-assets mark eventually.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.