Bank Stress Tests: The Bar Keeps Getting Higher

As stress-test results loom, U.S. banks may face barriers to sharply increasing capital returns

By Aaron Back

Banks are better positioned than ever to withstand the Federal Reserve’s annual stress tests.

But investors still shouldn’t count on smooth passage.

Sometime this month, the Fed will unveil the latest results of this exercise under which banks have to show how they would contend with myriad challenges including a financial shock and global recession. This is crucial to investors in bank stocks: The tests determine how much banks can pay out in dividends and share buybacks. Around a week after the results are published, the Fed will say whether it has approved or rejected individual bank capital-return plans.

The good news is that lenders have steadily built up capital in the year and a half since the last tests. This gives them substantial buffers to get through the Fed’s adverse scenarios. The six biggest U.S. banks all essentially passed the last round. That said, Bank of America BAC 0.81 % had to resubmit its plan, and others, including J.P. Morgan Chase JPM 0.64 % and Goldman Sachs, GS 0.31 % had to tweak their capital-return requests.

Since the third quarter of 2014, the starting point for the previous tests, these six banks have grown their common equity Tier 1 capital ratios—the most important measure of balance-sheet strength—by around 1 percentage point, to 12.1% on average. That is a strong position.

The bad news is that the Fed’s risk scenarios are much harsher this time around. Under the most extreme scenario, banks must envision a global recession that drives U.S. unemployment up by 5 percentage points, a bigger jump than in previous tests, to 10%. In a first, the Fed also has asked banks to anticipate what would happen if rates on short-term Treasury notes fell into negative territory.

This opens up several unknowns. If, for example, the Fed thinks a bank’s technical systems for trading bonds aren’t prepared for negative rates, that could be grounds for a failing grade.

It is important for investors to remember that banks’ capital plans are assessed both on quantitative and qualitative grounds. So it isn’t enough to simply pass the stress tests on a numerical basis. The Fed can still turn around and fail a bank for more subjective reasons, as has happened in the past.

What’s more, banks are already looking ahead to stress tests in 2017 and beyond. In these, the Fed could add to the capital that banks deemed globally significant must hold, even under severe scenarios. The need to prepare for this could affect how much capital banks are willing to send back to shareholders currently, says Credit Suisse analyst Susan Roth Katzke.

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