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Fed Gives a Thumbs Up to Capital Plans of 34 Banks

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Following the release of the Dodd-Frank Act supervisory stress test 2018 (DFAST 2018) results last week, the Federal Reserve approved the capital plans of 34 financial institutions out of the 35 participating (including the U.S. units of foreign banks with $50 billion or more in total consolidated assets) in the Comprehensive Capital Analysis and Review (CCAR).

However, the capital plan of the U.S. holding company of Germany-based Deutsche Bank (DB - Free Report) has been rejected by the Fed on qualitative reasons. Notably, the bank’s plan failed to receive consent on flaws in assumptions for forecast of revenues and losses.

Moreover, the capital plans of Goldman GS and Morgan Stanley (MS - Free Report) received conditional consent with their total dividend payouts and stock buybacks to be maintained at the current levels. Additionally, State Street Corporation’s (STT - Free Report) plan has been given a green signal with the clause of improving its hypothetical lending risks analysis with other big banks.

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

"Even with one-time challenges posed by changes to the tax law, the CCAR results demonstrate that the largest banks have strong capital levels, and after making their approved capital distributions, would retain their ability to lend even in a severe recession," said Fed’s vice chairman Randal Quarles.

Root of the Capital Rules

Currently authorized under the Dodd-Frank financial-services law, these stress tests were introduced after the 2008 financial crisis. During the economic downturn, big financial institutions like Lehman Brothers collapsed, while several others were on the verge of a meltdown. Such a turbulent situation 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.

These major banks, now, have the privilege to raise dividends and buy back shares. 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.

This apart, the Fed requires the big banks to maintain a supplementary leverage ratio (SLR) of at least 3% of their assets and certain other positions.

Banks that Aced

Wells Fargo (WFC - Free Report) , Citigroup Inc. (C - Free Report) , Fifth Third Bancorp (FITB - Free Report) , KeyCorp (KEY - Free Report) , M&T Bank Corporation (MTB - Free Report) , JPMorgan (JPM - Free Report) , Bank of America (BAC - Free Report) , U.S. Bancorp (USB - Free Report) and PNC Financial (PNC - Free Report) are among the major banks which received the Fed’s green light to raise their dividends or repurchase shares.

Among these, M&T Bank currently has a Zacks Rank #2 (Buy), while all other banks carry a Zacks Rank of 3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Since the first round of stress tests, there has been substantial increase in capitals of U.S. firms. The common equity capital ratio has also more than doubled from the 5.2% in first-quarter 2009 to 12.3% in fourth-quarter 2017 of the 35 bank-holding companies which participated in the 2018 CCAR. Such positive results reflect rise in common equity capital from about $800 billion to more than $1.2 trillion during the same period.

Recovery on the Way

Given the tax cuts and easing of stringent regulations, banks’ optimism has yielded results. With the capital plan approvals, banks keen to reward shareholders by enhancing the size of their capital-deployment plans (raising dividends and repurchasing shares) have announced respective dividend hikes and share repurchase plans.

Nevertheless, the Fed’s approval to increase dividend payment and accelerate the share buyback program will definitely help banks attract more investments, moving ahead.

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