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Banks Clear Fed's Stress Test: Bigger Payout to Follow?

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The Federal Reserve’s first round of stress test this year reflects that the nation’s biggest banks are ‘well capitalized.’

On Thursday, the Fed released the Dodd-Frank Act supervisory stress test 2018 (DFAST 2018) results. It shows that all 35 banks (including the U.S. units of foreign banks with $50 billion or more in total consolidated assets) are adequately capitalized to survive under tremendously difficult economic conditions.

The tests, conducted annually since 2009, are a must for big banks. These are designed to ensure that these banks are in a healthy position to handle crisis during an economic downturn.

The Fed’s Vice Chairman Randal Quarles said, “Despite a tough scenario and other factors that affected this year’s test, the capital levels of the firms after the hypothetical severe global recession are higher than the actual capital levels of large banks in the years leading up to the most recent recession.”

Detail Analysis of Results

This year’s stress test was the toughest, with severe adverse scenario featuring a severe global recession and the U.S. unemployment rate increasing to 10% along with a steepening Treasury yield curve. Further, changes in tax rates had an adverse impact on banks’ financials as the tax law eliminated some beneficial tax treatments that inclined to increase net income at the time of financial crisis.

Under this hypothetical scenario, these banks will incur a loss of $578 million. Notably, the projected losses included $113 billion from credit card loans for the banks, at an equal level with trading and counterparty positions. Also, the Common Equity Tier 1 (CET1) capital ratio (in aggregate) would fall to 7.9% from an actual 12.3% in fourth-quarter 2017. Notably, the figure is well above the 4.5% minimum mark set by regulators.

Wells Fargo (WFC - Free Report) reported CET1 ratio of 8.6%, highest among the four big banks. The other three — Bank of America (BAC - Free Report) , JPMorgan (JPM - Free Report) and Citigroup (C - Free Report) — had their ratios above 7%. All these stocks currently carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Apart from this, the Fed requires the big banks to maintain a supplementary leverage ratio (SLR) of at least 3% of their assets and certain other positions. However, in this year’s test, Goldman (GS - Free Report) and Morgan Stanley (MS - Free Report) have the last two positions with SLRs of 3.1% and 3.3%, respectively. So, this might result in these two companies adjusting their capital plans.

In a statement, Goldman commented that it did not agree with the Fed’s stress test results and intends to discuss the “divergence” before next week’s test. Additionally, Morgan Stanley stated that the results “may not be indicative of the capital distributions that we will be permitted to make.”

Notably, in response to recently passed Economic Growth, Regulatory Reform, and Consumer Protection Act, the Fed dropped CIT Group, Comerica Incorporated (CMA - Free Report) and Zions Bancorporation from this year’s test. The act exempts banks with total consolidated assets of less than $100 million from this annual exercise.

A Bigger Payout Possible

Banks are optimistic, given the tax cuts and easing of stringent regulations. They are keen to reward shareholders by enhancing the size of their capital deployment plans (raising dividends and repurchasing shares).

According to a Financial Times report, shareholders of 22 of the largest lenders are projected to receive around $170 billion in dividends and stock buyout in 2018, nearly 25% more than last year. Among these, JPMorgan, Wells Fargo (despite facing several probes and lawsuits related to business misconducts), Bank of America and Citigroup are expected to lead the race.

But the clearance of the stress test does not automatically lead to the conclusion that the banks qualify for bigger capital deployment. The companies will have to wait till Jun 28 for approval of their capital plans.

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