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Banks' Capital Plans Approved: Shareholders to Get Wealthier

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In a vote of confidence for the banking industry, the Federal Reserve has approved the capital plans of all the 18 financial institutions (including the U.S. units of foreign banks with $50 billion or more in total consolidated assets). This time, payouts (in terms of quarterly dividend and share buybacks) are expected to get bigger, with the same likely to exceed the projected earnings for a few banks.

However, there was a slight scare for JPMorgan (JPM - Free Report) and Capital One (COF - Free Report) as they had to alter and resubmit capital plans to remain above the Fed’s regulatory minimum capital levels. Besides, the U.S. unit of Credit Suisse (CS - Free Report) received the conditional approval, with the bank requiring “to address certain limited weaknesses in its capital planning processes” by Oct 27.

Surprisingly, Deutsche Bank’s (DB - Free Report) U.S. unit also received approval for its capital plan. This will provide substantial boost to the financials of the bank, which has been facing several concerns. Earlier in 2015, 2016 and 2018, the unit’s plan was rejected by the Fed.

Following the approval, most of the banks announced their 2019 capital plans. As we see in the table below, there will be a significant improvement in shareholder value:

The capital plan approval and subsequent expectation of substantial increase in payouts cheered investors, with stocks of almost all the participating financial institutions ending the day in green. This positive development may boost the bank stocks, which have been trailing the broader markets amid several concerns, including the Fed’s stance on interest rates and assumption of economic slowdown.

The Annual Exercise

Capital plan approval is part of the annual exercise conducted in two stages by the Fed (authorized under the Dodd-Frank financial-services law) to assess the resilience of the banking industry. In its 10th year of implementation, the process has helped the banking industry to significantly raise capital levels.

Per the Fed statement, “the largest and most complex banks have more than doubled their common equity capital from around $300 billion to roughly $800 billion” this year.

During the 2008 financial crisis, big financial institutions like Lehman Brothers collapsed, while several others were on the verge of a meltdown. So, the U.S. government had to infuse billions of dollars into credit markets and save the entire financial system from crumbling.

This year’s stress test was the toughest, with severe adverse scenarios featuring a severe global recession and a steeper downturn in the U.S. economy. Further, the 10-year Treasury declined to a trough of around 0.75%. Also, in equities, the banks were required to factor in substantially more volatility, with the U.S. Market Volatility Index reaching 70%.

Additionally, the scenario included the U.S. unemployment rate increasing to 6-10% along with slump in real estate prices and heightened stress in corporate loan markets. Under this hypothetical scenario, these banks will incur a loss of $410 million, narrower than total losses of $464 billion projected in the worst-case hypothetical scenario for the 18 firms in 2018.

Notably, the Common Equity Tier 1 (CET1) capital ratio (in aggregate) would fall to a low of 9.2% from an actual 12.3% in fourth-quarter 2018. The figure is well above the 4.5% minimum mark set by regulators.

Road Ahead

This year, only financial institutions with assets of more than $250 billion were the part of this annual process. Earlier in February 2019, the central bank had excepted banks with assets between $100 billion and $250 billion from 2019 supervisory stress test. These banks will be required to undertake supervisory stress test alternate year, beginning 2020.

Big banks will have to undergo this two-stage process annually to get approval for their yearly capital deployments and for enhancing shareholder value. Further, the Fed’s approval to increase dividend payment and accelerate the share buyback program will help banks attract more investments.

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