The stress tests created for banks by USA regulators after the 2008 financial crisis may prove their worth this week, providing a timely message on banks’ hardiness in the midst of turbulence over last week’s vote by Britain to leave the European Union.
A senior Fed official, in a conference call with reporters, noted the broad improvement banks had made in recent years, saying they entered this year’s exam with more capital and higher-quality loans.
Bank of America investors, especially, will be paying close attention to those results. The second report, due out next Wednesday, is created to show more qualitatively how the 33 individual institutions that were required to take the test fared under the different scenarios. The more important announcement comes next week, when the Fed will release the results for each of the individual banks.
“Banks generally are doing pretty well on earnings, so there is capacity to increase their dividends”, said Matt Anderson, managing director at Trepp.
Findings are scheduled to be announced around 4:30 p.m. On Wednesday, the Fed will disclose whether it has green-lighted big banks’ plans to raise dividends or buy back additional shares. They have until Saturday to do so. Morgan Stanley and BMO Financial Corp produced the weakest Tier 1 leverage ratio – another measure of capital strength relative to assets – of 4.9 percent, under that scenario. Missing the mark on stress tests may mean that a bank would have to put off things like dividends and buybacks until regulators are satisfied with their strategy. The figures did not necessarily match up. The Federal Reserve uses its own independent projections of losses and incomes for each firm.
The week between the two stages allows the banks time to amend their capital plans if they see that the results of the first stage could lead to their current plans being rejected in the second stage. More advanced network analysis, such as that used by the Bank of Canada, can do a better job of addressing contagion effects.
Citigroup Inc, for example, has had surprising results for both reasons in the past. Prior to the adjustments, the banks’ capital ratios, including common equity Tier 1 ratio and Tier 1 leverage ratio, slipped below the required level.
“The “severely adverse” scenario features a severe global recession with the domestic unemployment rate rising five percentage points, accompanied by a heightened period of financial stress, and negative yields for short-term US Treasury securities”. In this scenario, the aggregate common equity capital ratio of the 33 firms fell from an actual 12.3 percent in the fourth quarter of 2015 to a minimum level of 10.5 percent.
Not that it lessens the blow to banks, if they fail. But, unknown to investors, Citigroup’s capital plan included steps that significantly improved its measure of strength.