Bremain Calm: Bank Stress Test Results

The recent fallout in the wake of Brexit has left many worried - not just in the UK and Europe - but in numerous countries across the world. Living in a global economy often means a crisis in one corner of the planet can have far flung consequences everywhere else but fortunately our critical financial institutions are more than ready for any possible aftershocks of turmoil from the recent referendum result.

Ever since the financial crisis of 2007-2009, the Federal Reserve has conducted bank stress tests to evaluate whether or not banks have enough capital to subsist in severe, hypothetical, economic calamities. This past week U.S. banks underwent the 6th round of stress tests required by the Federal Reserve and the 4th round required by the Dodd-Frank Act with favorable results. The banks that are tested are the nation’s largest bank holding companies (BHCs). These stress tests can be completed internally by banks as a part of their own risk management, but 33 banks (with $50 billion or more in total consolidated assets) are required to participate to potentially detect flaws or weak spots in the banking system at a premature stage. This way, if any bank were to be found with any issues, they could initiate preemptive action.

The yearly evaluation is comprised of two related programs: The Dodd-Frank Act supervisory stress testing and the Comprehensive Capital Analysis and Review (CCAR). The first program (CCAR), which had its results released on June 23rd, operates to “inform the Federal Reserve, financial companies, and the general public of how institutions’ capital ratios might change under a hypothetical set of economic conditions developed by the Federal Reserve.” The second program evaluates a bank holding company's capital adequacy, capital planning process, and planned capital distributions.

In the most recent test, there were three scenarios that were analyzed. These scenarios consist of a severely adverse scenario, an adverse scenario, and global market shock and counterparty default components. The adverse and severely adverse scenarios are not expectancies, but relatively hypothetical situations that are intended to evaluate the strength of BHC’s and their resilience to a harsh economic environment. The global market shock and counterparty default components consist of add-ons to the macroeconomic conditions in the two other scenarios. Based on last week’s results, these financial institutions are showing an increase in capital levels and an improvement in credit quality, further reinforcing their capability to lend to households and companies during a severe recession. Assessing capital levels is crucial to the financial system, banking organizations, and the economy because the outcome reflects how many losses can be taken and helps to ensure the losses are carried by shareholders.

With one component of the annual stress tests being released last week, the second component (CCAR) was released yesterday. The CCAR results show the evaluations of BHC’ capital adequacy, capital planning process, and planned capital distributions. This also contains decisions made by regulators on whether or not to grant banks authority to distribute capital to shareholders through dividends or share buybacks. The Federal Reserve approved the capital plans of 30 banks. When the Federal Reserve considers a firm's capital plans, they consider qualitative or quantitative factors. Based on qualitative concerns, the plans of Deutsche Bank and Santander Holding, USA, Inc. were not approved; this is the second year in a row that they failed this portion of the annual test. As a result, these two banks are not allowed to make any capital distribution unless they are authorized by the Fed. In other words, they cannot issue dividends or make share buybacks until they establish a new plan. Morgan Stanley was not objected, but is required to submit a new capital plan by the end of the fourth quarter.

The passing of the stress tests by the banks should be welcoming news to investors. Although, with the Brexit results taking the world and markets by surprise, there should be some reassurance considering how the hypothetical scenarios provided in the stress tests are more severe than what banks have had to face thus far in regards to the historic vote, further supporting that U.S. banks are relatively prepared for undetermined future economic fallouts and market shocks.