Biggest banks clear their first hurdle in US Fed Reserve's stress tests

A man walks past the Federal Reserve building in Washington.
A man walks past the Federal Reserve building in Washington. PHOTO: REUTERS

NEW YORK (BLOOMBERG) - Thirty-four of the largest banks operating in the United States cleared a Federal Reserve stress test of their ability to withstand economic shocks, showing firms are getting the hang of the once-dreaded reviews - a trend that may continue if the Trump administration dials them back.

Every bank subject to the annual tests' first phase exceeded minimum thresholds, though Morgan Stanley trailed the rest of Wall Street on a key measure of leverage - the second year it performed worse than peers on one of the main metrics. Last year, during a second phase examining proposals to pay out capital to shareholders, the bank was forced to resubmit its plan to address a "material weakness". Results from that round are due next week.

"This year's results show that, even during a severe recession, our large banks would remain well capitalized," Fed Governor Jerome Powell said in a statement announcing the central bank's findings Thursday.

The exams, started after the 2008 market crash, assess how banks would handle hypothetical turmoil, such as surging unemployment, a sharp drop in housing prices or an extended stock slump. The reviews have encouraged the 34 banks to add more than US$750 billion (S$1.04 trillion) in common equity capital since 2009, with a focus on safe and less profitable businesses. Firms that handily clear the first phase typically have more room to make payouts to shareholders.

The tests have become less dramatic in recent years with fewer quantitative failures. And under regulators selected by President Donald Trump, that may continue. The Treasury Department issued a report last week proposing tests occur less frequently, that highly capitalized banks be exempt from the process and that one of the toughest hurdles be scrapped.

Thursday's announcement covered what's known as the Dodd-Frank Act Stress Test, which measures banks' capital under stress over nine quarters. This year, the Fed projected supplementary leverage ratios at the largest banks. Morgan Stanley's projected 3.8 per cent ratio in a potential economic downturn was lowest - though it still cleared the 3 per cent minimum.

"They were the most aggressive for the longest time going into the credit crisis," said David Hendler, the founder of New York-based research firm Viola Risk Advisors. "They're doing better but still aren't generating enough economic earnings to backfill for a systemic shortfall." A spokesman for Morgan Stanley declined to comment.

Overall, officials found that in the most severe scenario, companies would have suffered about US$383 billion in losses on loans. Among other conclusions: Bank of America Corp. would suffer a US$26.4 billion hit to its pretax profit under that scenario, the most of any lender.

Goldman Sachs Group's projected loan-loss rate of 8.1 per cent was surpassed only by commercial lenders or card issuers such as American Express, Capital One Financial Corp, and Discover Financial Services.

Wells Fargo & Co's US$7.7 billion in trading and counterparty losses came close to firms with larger Wall Street operations, with Morgan Stanley at US$9.5 billion. JPMorgan Chase led the group with US$25.2 billion in losses.

The biggest US banks' own estimates for loan losses were more optimistic than the Fed's - a trend that has arisen in past years as well. For example, Wells Fargo, a major lender to companies and for commercial real estate, estimated it would lose almost US$20 billion less than the US$50.4 billion the Fed projected. Bank of America's calculation was US$12.1 billion less than the Fed's US$45 billion.

Next week, the Fed will release findings from its Comprehensive Capital Analysis & Review. That phase is closely watched by shareholders because it dictates whether lenders can increase dividends and buy back stock. Before Thursday's results, analysts predicted banks would be able to return more than US$120 billion to shareholders over the next four quarters, or about 85 percent of their profit. With the Dodd-Frank results in hand, now banks have the option of revising their capital plans before CCAR is released.

Some analysts have questioned whether the Fed might flag Wells Fargo in the latter exam this year after regulators found its employees may have opened more than 2 million accounts without customers' approval. The scandal triggered fines, lawsuits, a Justice Department investigation and a leadership shakeup that included the ouster of the company's chief executive officer.

But for the most part, the stress tests have been getting less stressful.

Fed Governor Powell said recently that regulators will share more information with the industry during next year's exams after bankers complained the process was too opaque. Specifically, the tests will feature a sample portfolio to show how certain assets would be affected by the Fed's invented crisis, he said.  Even one of the tests' staunch champions, former Fed Governor Daniel Tarullo, said before he stepped down in April that it might be time to ease up on the qualitative side of the test for Wall Street banks, as the Fed already did for mid-size lenders. That component assesses how firms plan for managing capital and risk.

Mr Trump may soon nominate a Fed vice chairman for banking supervision, who will oversee the tests. The president also will be able to appoint a new Fed chair when Janet Yellen's term expires in February. Easing constraints on banks has been a priority for Trump, so investors expect him to pick candidates who will dial back the reviews.

There are risks if the Fed is too aggressive. Strong numbers show banks have learned how to position their portfolios to pass tests, and not necessarily lend as much as possible, said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc. And by subjecting banks to the same model, the regulator might push them into businesses that turn out to be perilous, she said.

"If the Fed bets wrong and treats one particular trading strategy as low risk and it's high risk, all the banks will have taken that low-risk bet and it will have turned out very badly," she said.