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After the release of the Dodd-Frank Act supervisory stress test 2013 (DFAST 2013) results last week, the Federal Reserve came up with the approval of capital plans of 14 financial institutions out of 18 in the Comprehensive Capital Analysis and Review (CCAR). Two banks have received approval subject to certain conditions, while the capital plans of the other two have been rejected.

The Fed’s approval of capital plans for most of the major U.S. banks reflects stability in the banking system to a great extent.

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, they were asked to submit their capital plans to the Fed. It was intimated to these banks 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 and AIG 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 crumbling.

Moreover, the first CCAR was conducted by the Fed in early 2011. Notably, in Nov 2011, the Fed adopted the capital plan rule under which bank holding companies having consolidated assets of $50 billion or more were asked to submit annual capital plans to the Fed for review. As per the rule, banks need to include their internal processes for evaluating capital adequacy, capital actions including common stock issuance, dividends and share repurchases along with premeditated capital actions over a nine-quarter planning horizon.

The Fed’s latest stress test scenario projections include input data supplied by the 18 banks participating in DFAST 2013 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.

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

Wells Fargo & Company (WFC - Analyst Report), The Bank of New York Mellon Corporation (BK - Analyst Report) and U.S. Bancorp (USB - Analyst Report) are among the major banks that have received clearance from the Fed to raise their dividends or repurchase shares.

Another major bank, Bank of America Corporation (BAC - Analyst Report), which pays a quarterly dividend of only a penny, received a nod for the repurchase of up to $5.0 billion of common stock and the redemption of approximately $5.5 billion in preferred stock. However, BofA’s capital plan did not include a dividend hike.

Notably, Citigroup Inc. (C - Analyst Report) which failed last year’s stress test received the Fed’s approval for $1.2 billion worth of share repurchases through first quarter 2014. This would definitely boost shareholders’ confidence. However, the company did not request a change in its dividend levels and currently pays a quarterly common stock dividend of 1 cent per share.

Moreover, though The Goldman Sachs Group Inc. (GS - Analyst Report) and JPMorgan Chase & Co. (JPM - Analyst Report) received the Fed’s approval for their proposed capital plans, these two giants will need to resubmit the plan by the end of third quarter 2013. The banks have been asked to resubmit the capital plans considering the weaknesses recognized in their capital planning processes.

Banks on Shaky Ground

Among 18 bank holding companies which submitted their capital plan to the Fed in Jan 2013, the auto lender, Ally Financial, majority-owned by U.S. taxpayers was the only bank which failed to meet the minimum requirement of 5% Tier 1 common capital ratio. Therefore, with 1.5% capital ratio, Ally remains unstable, struggling with troubled mortgages and other distressed businesses and received Fed’s rejection of its capital plan.

Apart from Ally, BB&T Corporation’s (BBT - Analyst Report) capital plan has also been rejected by the Fed based on certain “qualitative” reasons. Though BB&T’s proposed capital plan was not disclosed, Fed specifies that the recent change in the calculation of certain assets by the company will result in lower capital ratio as compared with its prediction. Therefore, BB&T will be resubmitting the capital plan shortly.

Recovery on the Way

This, however, is not the end. The big 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 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.

The banking sector presented a slightly improved picture in 2012 compared to 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 share buyback program will definitely help banks attract more investments going forward.

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