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At present, American banking giants are better positioned to withstand an economic downturn. This was disclosed by the Federal Reserve while releasing the Dodd-Frank Act Stress Test 2014 (DFAST 2014) results.

All the bank holding companies (BHCs) with $50 billion or more in total consolidated assets are part of DFAST 2014. Among 30 BHCs that submitted their capital plans to the Fed in Jan 2014, UT-based Zions Bancorporation (ZION - Analyst Report) with Tier 1 common capital ratio of 3.5% failed to meet the minimum requirement of 5%. Further, these 30 banks altogether account for approximately 80% of total banking assets in the country.

Overall, under the most extreme stress scenario, the banks’ aggregate Tier 1 common capital ratio will decrease to 7.6% in the first quarter of 2015 from 11.5% in the third quarter of 2013. Conversely, the ratio is significantly higher than 30 banks’ actual ratio of 5.5% in the beginning of 2009.

Moreover, an extreme recession is expected to lead to $501 billion of losses. These included anticipated loan losses of $366 billion as well as $98 billion losses in trading and counterparty at the eight banks that have substantial trading or custodial operations.

Nevertheless, the clearance of stress test does not automatically lead to the conclusion that the banks qualify for additional capital deployment. The banks will have to wait till March 26 for approval of their capital plans.

Successful Banks

History repeated itself. In similarity to last year’s stress test, smaller banks fared better in comparison to Wall Street biggies like Citigroup Inc. (C - Analyst Report), JPMorgan Chase & Co. (JPM - Analyst Report) and The Goldman Sachs Group, Inc. (GS - Analyst Report). With 13.3% capital ratio, State Street Corp. (STT - Analyst Report) topped the list, followed by The Bank of New York Mellon Corp. (BK - Analyst Report) and Discover Financial Services (DFS - Analyst Report), each having a ratio of 13.1%.

Notably, in its latest capital plan, Discover Financial has asked for additional $1.6 billion worth of share repurchase through the first quarter of 2015 and a 20% rise in its quarterly cash dividend. Currently, the company has $2.4 billion share repurchase authorization (remaining $1.1 billion as of Dec 31, 2013) and pays quarterly cash dividend of 20 cents per share.

Among other major banks, Goldman with 6.8% capital ratio performed well in comparison to the 2013 stress test while Citigroup’s ratio fell to 7% from the prior-year test results. Further, JPMorgan held a steady capital ratio of 6.3%.

Additionally, Ally Financial Inc. (majority-owned by U.S. taxpayers) which had failed to clear the stress test last year, recorded Tier 1 common capital ratio of 6.3%. Notably, M&T Bank Corp. (MTB - Analyst Report), Bank of America Corp. (BAC) and Morgan Stanley (MS - Analyst Report) occupied the bottom three places with ratios of 5.9%, 6.0% and 6.1%, respectively.

2014 Stress Test Scenarios

The Fed had three stress test 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%.

Background Story

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 and American International Group, Inc. (AIG - Analyst Report) collapsed and several other big banks were on the verge of collapse. Hence, the U.S. government was compelled to infuse billions of dollars into credit markets and save the entire financial system from failing.

Stress tests have been annually conducted since 2009. Till last year, 18 banks were part of it. Notably, the 2014 stress test included 12 more banks including Comerica Inc. (CMA - Analyst Report), Discover Financial, KeyCorp (KEY - Analyst Report), Zions, along with certain subsidiaries of foreign banks like BMO Financial, a unit of Bank of Montreal (BMO) of Canada and BBVA Compass Bancshares, held by Spain’s Banco Bilbao Vizcaya Argentaria SA (BBVA), among others.

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 deeper than expected. Since then, the stress test rounds are precautionary measures amid a recovering economy.

Further, as per the Dodd-Frank Act, bank holding companies participating in the Fed’s stress test have to conduct two company-run stress tests every 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.

Road to Recovery

Conducting stress tests is the Fed’s way of evaluating the overall performance of the banking sector. These tests help banks to gear up and improve their weak capital levels, which threaten the economy. Also, this could ultimately translate to less involvement of taxpayers’ money for the bailout of troubled financial institutions.

However, the government must necessarily set some policies so that every industry participant contributes to the overall profitability. While major banks benefited greatly from the various programs launched by the government, that has not been the case with many smaller banks.

However, the banking sector presented an improved picture in 2013 compared to 2012 and 2011. Lingering issues like depressed home prices, loan defaults and unemployment levels are not so prominent compared to the past few years.

Though economic uncertainty is still there, banks are actively responding to every legal and regulatory measure. In fact, this has positioned banks better to face possible challenges in the future. As the sector is undergoing a radical structural change, it is expected to witness headwinds in the near to mid term.

Nevertheless, the approval from the Fed to increase dividend payouts and accelerate share buyback program will definitely help banks attract more investments going forward. Hence, it can be said the economy is on the track to recovery.

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