The Federal Reserve said 17 of the 18 largest U.S. banks could withstand a deep recession and maintain capital above a regulatory minimum.
Only Ally Financial Inc., the auto lender majority-owned by U.S. taxpayers, fell below a 5 percent Tier 1 common ratio, a regulatory minimum and measure of financial strength, according to data released by the central bank in Washington. Morgan Stanley showed a minimum Tier 1 common ratio of 5.7 percent in the test, and Goldman Sachs Group Inc. showed a ratio of 5.8 percent.
“The nation’s largest bank holding companies have continued to improve their ability to withstand an extremely adverse hypothetical economic scenario and are collectively in a much stronger capital position than before the financial crisis,” the central bank said in a press release.
Since the 2008-2009 financial crisis, U.S. regulators have tried to minimize the odds of another taxpayer rescue, compelling U.S. banks to retain some earnings and reinforce their buffers against possible losses. With the economy in the fourth year of expansion, banks are benefiting from a housing market rebound, falling mortgage delinquencies and record-low short-term interest rates that boost earnings.
Projected losses for the 18 banks under a scenario of deep recession and peak unemployment of 12.1 percent would total $462 billion over nine quarters, the Fed said. The aggregate Tier 1 common capital ratio would fall from an actual 11.1 percent in the third quarter of 2012 to 7.7 percent in the fourth quarter of 2014. The firms represent about 70 percent of the assets in the U.S. banking system.
The Fed said in a release that the “projections should not be interpreted as expected or likely outcomes for these firms, but rather as possible results under hypothetical, severely adverse conditions.” A Fed official said on a conference call with reporters that the severely adverse scenario represents a financial calamity of greater magnitude than any two-year period in the last 100 years except for the Great Depression.
The biggest sources of losses are those “on the accrual loan portfolios and trading and counterparty losses from the global market shock,” the Fed said in its release. “Together, these two account for nearly 90 percent of the projected losses” for the 18 banks under the severely adverse scenario.
“We are entering this year with a stronger capital base and we are further through the credit cycle,” so fewer loans are going bad, said R. Scott Siefers, a managing director at Sandler O’Neill & Partners in New York. “Even though banks are paying out more of their earnings than a couple of years ago, there has still been an increase in retained earnings,” which bolsters capital.
The Fed on March 14 will release results of a second stress test that focuses on the lenders’ capital plans, assessing how dividend or share-buyback increases would affect them. The central bank that day will inform banks whether they can increase payouts. The test results don’t forecast results for next week’s test, the Fed official said on the conference call, because the Dodd-Frank stress test doesn’t include forward-looking management decisions.
The KBW Bank Index, which tracks shares of 24 large U.S. banks such as JPMorgan Chase & Co., State Street Corp. and Capital One Financial Corp., has risen 9.7 percent this year, compared with the 8.3 percent gain of the Standard & Poor’s 500 Index.
The Fed said in November the largest banking groups had nearly doubled their Tier 1 common capital to $803 billion in the second quarter of last year from $420 billion in the first quarter of 2009.
The Fed derived the results today by following stress test guidelines in the Dodd-Frank Act, with bank dividends held constant and share buybacks or issuance not considered. The test is aimed at providing a standardized comparison of how bank capital fares during a deep recession.
“There needs to be much more market discipline over capital requirements,” said Hal Scott, a Harvard Law School professor and director of the Committee on Capital Markets Regulation, a research group of academics and industry leaders.
“What the stress test disclosure does is give markets much more information than they have had about the possibility of banks dealing with situations on a comparative basis,” Scott said. Bloomberg LP Chief Executive Officer Daniel Doctoroff is a member of the committee.
The Fed’s March 14 Comprehensive Capital Analysis and Review will be a more detailed test that incorporates forward- looking capital decisions of bank managers and requires financial institutions to meet specific criteria to pass. Both tests apply the same so-called severely adverse scenario, which subjects the loan and securities portfolios of banks with the shocks of a recession and soaring unemployment.
The Tier 1 common ratio measures a bank’s core equity, made up of common shares and retained earnings, divided by its total assets adjusted for risk using global banking guidelines. The ratio grew especially important during the financial crisis as investors applied extreme mark-downs on bank portfolios to see whether firms had enough core equity to absorb additional losses or the potential for balance sheet growth.
The Fed for the test gave banks 26 variables — ranging from interest rates to stock and home-price indexes — and showed how they would change through a baseline, adverse and severely adverse scenario.
Under the most adverse scenario, U.S. gross domestic product doesn’t grow or contracts for six consecutive quarters. Unemployment peaks at 12.1 percent, and real disposable income falls for five consecutive quarters. Stock prices tumble 52 percent, and house prices fall 21 percent.
This year’s CCAR for the first time provides banks with an early look at how they performed under the analysis, giving them a chance to revise their capital plans. If their capital can withstand those conditions without pushing ratios below regulatory levels, and if their analysis is rigorous enough, the Fed signs off.
The Fed conducted its first stress test in 2009, aimed at restoring confidence in banks by showing worst-case losses. In 2011, the central bank adopted a new approach to the tests that focused on banks’ plans for capital.
“The point is to bar capital distributions from under- capitalized or risk-prone bank holding companies, which happened a lot, with full Federal Reserve Board approval, even as the crisis was clearly revving up,” said Karen Shaw Petrou, co- founder of Federal Financial Analytics, a Washington firm that specializes in financial regulation analysis.
The 19 largest banks in 2007 paid out more than $43 billion in dividends as housing prices continued their fall, and an additional $39 billion in 2008 as the crisis began to accelerate, Patrick Parkinson, the former head of the Fed Board’s supervision and regulation division said in 2011. He is now a managing director at Promontory Financial Group LLC.
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