Federal Reserve releases first round of results of annual exams assessing banks’ health; second part is next Thursday
The Federal Reserve determined the largest U.S. banks were healthy enough to withstand a severe economic downturn and would continue lending during a crisis, as the industry posts record profits and prepares for a wave of regulatory relief.
The Fed’s “stress test” scenario for the 35 largest bank holding companies, which hold 80% of the assets at banks operating in the U.S., found the firms were “strongly capitalized” and would retain adequate capital levels in severely adverse conditions, according to the first round of results released Thursday by the central bank.
The positive scorecard indicates most of the banks are likely to win the Fed’s approval next week to increase dividends after a second round of results that will determine whether the firms pass or fail the annual stress-test exercise, put in place after the 2008 crisis. However, Goldman Sachs Group Inc. and Morgan Stanley barely cleared one of the key regulatory minimums of the first round.
Thursday’s results are the latest positive news for an industry that took years to dig itself out of the financial crisis and faced a tightened regulatory regime meant to prevent another period of financial turmoil. Congress and Trump-appointed regulators have taken steps to ease regulation and struck a cooperative tone with the industry, placing financial firms in a friendlier political climate at a time manufacturing, retail and other industries face uncertainty over U.S. trade policy.
“Despite a tough scenario and other factors that affected this year’s test, the capital levels of the firms after the hypothetical severe global recession are higher than the actual capital levels of large banks in the years leading up to the most recent recession,” Fed Vice Chairman for Supervision Randal Quarles said in a statement.
A senior Fed official said this year’s economic scenarios were the toughest to date, a response to the strong economy. One-time accounting changes related to last year’s tax law also handicapped some firms.
As a result, banks’ capital levels fell closer to the regulatory minimums than they had in recent years. The banks’ core common equity Tier 1 capital ratios collectively dropped as low as 7.9% during the scenario period, down from 12.3% in actual high-quality capital at the end of 2017. That is well above the 4.5% requirement. But it is still a smaller surplus than last year, when that ratio was 9.2%.
In certain cases, the cushion was much narrower. Goldman Sachs and Morgan Stanley, for example, just cleared their supplementary leverage ratios—a measure that includes lending and derivative exposure relative to their capital levels. Goldman Sachs was 3.1% and Morgan Stanley 3.3%, compared with a 3.0% minimum.
Goldman Sachs appeared to be caught off guard by the results. In a statement, the bank said that its own capital models “diverge” from the Fed’s, and it is “examining that divergence.” Goldman also said its capacity to return capital “may be higher than this year’s test would otherwise indicate.”
A Morgan Stanley spokesman said in a statement that the stress-test results “may not be indicative of the capital distributions that we will be permitted to make” and said it would give more detail next week.
Firms conduct their own internal tests using the Fed’s doomsday scenario. If after seeing the Fed’s results, a company determines it is at risk for failing, it can take a “mulligan” and resubmit more conservative shareholder payouts.
The Fed won’t take any direct action based on the results released Thursday. But they do signal how much capital the Fed will allow banks to return and could affect the size of the payouts that banks seek.
Banks have performed strongly in the initial round of stress tests for several years. In 2017, all firms also passed the more consequential second round, meaning the Fed didn’t have to limit any of the banks’ investor payouts.
Overall, the Fed calculated the largest U.S.-based bank holding companies would have loan losses of $429 billion under a hypothetical scenario that envisioned the U.S. unemployment rate rising to 10% and gross domestic product dropping 7.5%, with a steepening Treasury yield curve.
In contrast, banks are by many measures enjoying their strongest period in a decade. Boosted by a healthy economy and busy corporate clients, U.S. banks reported record profits for the first quarter, with $56 billion in net income, according to the Federal Deposit Insurance Corp.
The corporate tax cut in 2017 added about $7 billion to the bottom line for banks in the quarter. But even without that benefit, profit would still be at a record.
The biggest banks in particular are gobbling up market share from struggling overseas rivals and smaller U.S. lenders.
Thanks to a volatile market, stock-trading desks at the big five investment banks—
JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc.,Goldman Sachs and Morgan Stanley—had their best start to a year in 2018 since the financial crisis.
The Fed exempted three banks that had submitted capital plans for the stress tests, thanks to the new banking law increasing a threshold for stricter regulatory supervision to $250 billion in assets from $50 billion. Those firms were CIT Group Inc., Comerica Inc. and Zions Bancorp. In the future, the Fed could also ease the stress tests for firms with $100 billion to $250 billion in assets.
Regulators also are working on other rule changes that would benefit big banks, including making it easier to comply with the Volcker rule, which bars banks from hedge-fund-like trading activities, and changing a capital requirement known as the enhanced supplementary leverage ratio, which requires the largest banks to maintain a minimum proportion of capital to assets.
Worries that rising short-term interest rates would squeeze banks are so far not being borne out. Americans still keep a huge percentage of their deposits at the biggest retail banks—JPMorgan, Bank of America and Wells Fargo & Co.—as those firms pay some of the lowest rates on savings accounts.
Banks continue to find ways to lend at higher rates. Commercial and industrial loan growth has picked up of late, and the U.S. market for loans to risky companies hit a trillion dollars for the first time this year.
The Fed’s stress tests are released in two parts. On Thursday, the Fed assessed the health of the banking system as a whole and released “quantitative” results, or calculations showing how banks fared during hypothetical scenarios. Next week—on June 28—the Fed will say whether banks passed or failed, publishing a second version of the “quantitative” results reflecting the individual capital plans of each bank and in some cases evaluating “qualitative” issues such as weaknesses in risk-management.
The qualitative release next week remains a potential tripping wire for large banks that are well-capitalized but have faced rebukes from regulators on other aspects of their operations, including consumer harm.
Vulnerable banks may include the U.S. operations of Deutsche Bank AG, which was designated about a year ago by the Fed as “troubled,” or Wells Fargo & Co., which is still weathering regulatory punishments two years after the customer-abuse scandal broke, including a $1 billion fine and limitations on its ability to expand its banking business.
Deutsche Bank exceeded the Fed’s stressed-scenario minimums. It has struggled in past years to pass the qualitative portion of the tests, even for just part of its U.S. business. This is the first year Deutsche Bank’s full U.S. holding company has been subject to the tests, raising uncertainty among investors and analysts about next week’s results.
The stress tests were first conducted in 2009 to help convince investors that the banking system wasn’t about to collapse. Early on, they were a nail-bitingly public process for banks that was scrutinized by the public and investors for signs of weakness.
But today, the tests appear less relevant to market observers.
“There’s just not that much excitement any more,” said Michael Alix, a partner at consulting firm PwC and a former official at the Federal Reserve Bank of New York. “It’s become more the expectation that institutions are going to pass.”