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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.

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.

Successful Banks

Wells Fargo & Company (WFC - Analyst Report), JPMorgan Chase & Co. (JPM - Analyst Report), The Bank of New York Mellon Corporation (BK - Analyst Report), U.S. Bancorp (USB - Analyst Report), Morgan Stanley (MS - Analyst Report), Capital One Financial Corporation (COF - Analyst Report) and State Street Corporation (STT - Analyst Report) 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 (BAC - Analyst Report) and The Goldman Sachs Group Inc. (GS - Analyst Report) 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 distribution plans.

Banks on Shaky Ground

Among 30 bank holding companies which submitted their capital plan to the Fed in Jan 2014, UT-based lender, Zions Bancorporation (ZION - Analyst Report) 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 Citigroup Inc. (C - Analyst Report) along with the plans of U.S. units of London-based HSBC Holdings plc (HSBC), The Royal Bank of Scotland Group plc (RBS - Snapshot Report) and Spain’s Banco Santander, S.A. (SAN) 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 scenario.

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 financial institutions.

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 recovery.

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