Following the release of the Dodd-Frank Act supervisory stress test 2016 (DFAST 2016) results last week, the Federal Reserve approved the capital plans of 30 financial institutions out of 33 in the Comprehensive Capital Analysis and Review (CCAR). However, the capital plans of two of the remaining three have been rejected based on certain qualitative concerns, while the third plan received conditional consent on resubmission by Dec 29.

The Fed’s nod to most of the major U.S. banks reflects stability in the banking system to a great extent. All the bank holding companies (BHCs) with $50 billion or more in total consolidated assets are part of DFAST 2016. Notably, 33 BHCs that submitted their capital plans to the Fed in Apr 2016 account for approximately 80% of the total banking assets in the country.

The banks now have the privilege to increase dividends and buy back shares. Amid concerns that banks might not have sufficient capital to counter another financial crisis, the financial institutions were asked to submit their capital plans to the Fed. The banks were further intimated that payment of higher dividends will be restricted if they fail to meet the requirement of 4.5% Common Equity Tier 1 (CET1) capital ratio, among other requirements.

Root of the Capital Rules

Currently authorized under the Dodd-Frank financial-services law, the stress tests were first introduced after the 2008 financial crisis. During the economic downturn, big financial institutions like Lehman Brothers collapsed while several others were on the verge of a meltdown. Such a situation compelled the U.S. government to infuse billions of dollars into credit markets and save the entire financial system from crumbling.

Stress tests have been annually conducted since 2009. The environment of the last 6 rounds of stress tests along with the latest one is different from the first round. Conducted when the country was reeling under tremendous recessionary pressure, the first test was aimed at estimating how much the banks would lose if the economic downturn proved deeper than expected. Since then, the stress test rounds are precautionary measures amid an economic recovery.

The Federal Reserve’s latest stress test scenario projections include input data supplied by the 33 banks participating in DFAST 2016 and models created by the regulatory staff and evaluated by a group of Fed economists and analysts. These models were developed with the intention to inculcate the impact of the macroeconomic and financial market factors that are included in the Supervisory Stress Scenario and distinctive factors of the banks’ loans and securities portfolios, trading as well as other factors affecting losses, revenue and expenses.

Moreover, the Fed's stress test was conducted to find out whether the banks have enough capital to survive another financial crisis under the severely adverse scenario that assumed a decline of about 50% in equity prices, unemployment rate at a peak of 10% and a sharp fall in gross domestic product.

Last year, the 31 banks that participated passed the stress test. However, this time the capital levels of banks exhibited improvement despite tougher conditions. This year’s severely adverse scenario also featured a path of negative interest rates.

Despite this, the declines in the four capital ratios projected by the Fed were less acute. The projections ranged from 2.6 percentage points to 3.9 percentage points compared with last year’s range of declines from 2.9 percentage points to 5.2.

Under the most severe scenario, the 33 banks would suffer $385 billion in loan losses over nine quarters. Also, $113 billion in trading losses were included in the overall losses of $526 billion projected for the 33 BHCs in the aggregate over the nine quarters.

In aggregate, Common Equity Tier 1 (CET1) capital ratio would fall from an actual 12.3% in the fourth quarter of 2015 to a post-stress level of 8.4% in the first quarter of 2018. However, that is well above the 4.5% minimum set by regulators. Moreover, the Fed indicated that the 33 banks’ common equity has been increased by more than $700 billion since 2009 which raised the ratio of high-quality capital to risk-weighted assets to 12.2% in the first quarter of 2016 from 5.5% in the first quarter of 2009.

Banks that Aced

Wells Fargo & Company (WFC Quick QuoteWFC - Free Report) , Citigroup Inc. (C Quick QuoteC - Free Report) , Fifth Third Bancorp (FITB Quick QuoteFITB - Free Report) , The Bank of New York Mellon Corporation (BK Quick QuoteBK - Free Report) , U.S. Bancorp (USB Quick QuoteUSB - Free Report) , The PNC Financial Services Group, Inc. (PNC Quick QuotePNC - Free Report) , Capital One Financial Corporation (COF Quick QuoteCOF - Free Report) and State Street Corporation (STT Quick QuoteSTT - Free Report) are among the major banks that have received clearance from the Fed to raise their dividends or repurchase shares.

Among other banks, M&T Bank Corporation (MTB Quick QuoteMTB - Free Report) submitted an adjusted capital plan last week, which also got approved.

Further, Morgan Stanley (MS Quick QuoteMS - Free Report) received contingent approval on submission of its revised capital plan by Dec 29, as certain loopholes in its capital planning processes were addressed by the Fed. However, Morgan Stanley is allowed to carry on with its share buyback and dividend increase plans for the time being.

Banks that Failed

Among the 33 BHCs which submitted their capital plan to the Fed in Apr 2016, the plans of the U.S. units of Germany-based Deutsche Bank AG (DB) and Spain’s Banco Santander, S.A. (SAN) have been rejected by the Fed based on certain “qualitative” reasons for the second consecutive year. The Fed believes that these banks have certain drawbacks in their capital planning processes and lack progress since Mar 2015.

Recovery on the Way

This, however, is not the end. Major banks will have to undergo the Fed’s stress test once every year. These would help increase the weak capital levels of banks, which are a looming threat to the economy. Also, these could eventually translate into lesser involvement of the taxpayers’ money for bailing out troubled financial institutions.

However, the government must necessarily frame certain policies so that every industry participant contributes to the overall profitability. While the bigger banks have benefited greatly from the various programs launched by the government, many smaller banks are trying to catch up.

Though economic uncertainty is a prevailing factor, banks are actively responding to every legal and regulatory pressure. In fact, this has positioned the banks well to encounter impending challenges. As the sector is undergoing a radical structural change, it is expected to witness headwinds in the near-to-mid term. However, entering the new capital regime will significantly improve the industry’s long-term stability and security.

Nevertheless, the approval from the Federal Reserve to increase dividend payment and accelerate the share buyback program will definitely help banks attract more investments going forward.

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