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Banks Show Second Straight Win in Fed Stress Test

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On Thursday, the Federal Reserve released the Dodd-Frank Act supervisory stress test 2016 (DFAST 2016) results, which reflected the continued stability in the banking system despite the Fed’s harsher hypothetical “severely adverse” scenario this time.

The second straight year of clearing the first part of the annual stress test reaffirms that the U.S. banking giants remain sufficiently capitalized to survive an extremely difficult economic scenario.

“The nation’s largest bank holding companies continue to build their capital levels and improve their credit quality, strengthening their ability to lend to households and businesses during a severe recession,” the Fed said in a statement.

Overall Results

Each of the 33 banks that were tested under the severely adverse scenario that assumed a decline of about 50% in equity prices, unemployment rate at a peak of 10% and a sharp fall in gross domestic product were able to stay above minimum required capital levels.

Last year, the 31 banks that participated also passed the stress test. However, this time the capital levels of banks exhibited improvement despite tougher conditions. This year’s severely adverse scenario also featured a path of negative interest rates.

Despite this, the declines in the four capital ratios projected by the Fed were less acute. The projections ranged from 2.6 percentage points to 3.9 percentage points compared with last year’s range of declines from 2.9 percentage points to 5.2.

Under the most severe scenario, the 33 banks would suffer $385 billion in loan losses over nine quarters. Also, $113 billion in trading losses were included in the overall losses of $526 billion projected for the 33 bank holding companies (“BHCs”) in the aggregate over the nine quarters under the severely adverse scenario.

In aggregate, Common Equity Tier 1 (CET1) capital ratio would fall from an actual 12.3% in the fourth quarter of 2015 to a post-stress level of 8.4% in the first quarter of 2018. However, that is well above the 4.5% minimum set by regulators.

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 till next week for the 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, financial stalwarts like Lehman Brothers collapsed and several other big banks were on the verge of collapsing. Such a situation compelled the U.S. government to infuse billions of dollars into credit markets and safeguard the entire financial system from such a fiasco in the future.

Individual Performance

The 33 banks altogether account for more than 80% of domestic banking assets. Among the 33 BHCs, Morgan Stanley MS, BMO Financial Corp, Huntington Bancshares Inc. HBAN and The Bank of New York Mellon Corp. BK have certain ratios within two percentage points of regulatory minimum.  This may create an obstacle in getting approval for their capital plans, which is expected to be announced next week for all the banks.

While Huntington has the lowest minimum CET1 capital ratio of 5% under a severely adverse scenario against the regulatory minimum of 4.5%, BMO Financial and Morgan Stanley have the weakest Tier 1 leverage ratio of 4.9% against the regulatory minimum of 4.0%.

Other major U.S. banks like JPMorgan Chase & Co. (JPM - Free Report) , The Goldman Sachs Group, Inc. GS, Citigroup Inc. C and Wells Fargo & Company WFC remained well above the minimum regulatory requirements in severe economic and market conditions.

Bank of America Corp. BAC and JPMorgan with 8.1% and 8.3% capital ratios, respectively, fared well compared with the prior-year test. Notably, Bank of America cleared the capital minimums in all categories exceeding the prior-year figures.

Final Thoughts

Though economic uncertainty still persists, 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 undergoes 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 Fed to increase dividend payment and to accelerate the share buyback program will definitely help banks attract more investments going forward.

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