By Ryan Tracy And Victoria McGrane
WASHINGTON--The largest U.S. banks are strong enough to keep
lending during a severe recession, the Federal Reserve said
Thursday, a sign that many banks will soon get permission to return
profits to investors by raising dividends or buying back
shares.
The Fed's annual "stress test" of banks' financial health found
all 31 of the biggest U.S. banks had enough capital to continue
lending during a hypothetical economic shock where corporate debt
markets deteriorate, unemployment hits 10% and housing and stock
prices plunge. The exams are designed to ensure large banks can
withstand severe losses during times of market turmoil without a
taxpayer bailout.
It was the first time since the tests began in 2009 that all
banks had capital levels above what the Fed views as a minimum
allowance. The banks will need to maintain those minimum capital
levels to pass the second round of stress tests on Wednesday, which
will determine whether a firm can return money to shareholders. Two
banks, Goldman Sachs Group Inc. and Zions Bancorp, had certain
capital ratios that came close to the Fed's minimum, which could
limit shareholder payouts.
The overall results buttress regulators' view that the financial
system is safer than before the Great Recession, in large part
because of loss-absorbing capital built up for the annual stress
test exercise. The Fed said the 31 banks' aggregate Tier 1 common
capital ratio, which shows high-quality capital as a percentage of
risk-weighted assets, dropped as low as 8.2% under the stressful
scenario, well above the 5.5% level measured in early 2009 and the
5% level the Fed considers a minimum allowance.
"Higher capital levels at large banks increase the resiliency of
our financial system," Federal Reserve Governor Daniel Tarullo said
in a statement.
The results could bolster big banks' push to return more of
their income to restless shareholders after years of conservative
payouts. The Fed will announce on Wednesday whether banks "pass" or
"fail" the second round of stress tests and can return their
requested amounts of capital to shareholders.
The Fed has loosened its hold on capital payouts somewhat but
they are still below precrisis levels. The payments of common-share
dividends at U.S.-owned banks in the stress test process rose to
$25 billion last year, according to data from Thomson Reuters, from
a low of $6.6 billion in 2010, when the banks were most severely
constrained. In 2007, those payouts totaled $44 billion. Citigroup,
Inc., which failed the tests last year and in 2012, hasn't been
permitted to boost its dividend since its 2008 taxpayer
bailout.
Changes in the Fed's test this year could limit payouts. Banks
with larger capital markets activities--like buying and selling
equity and debt instruments--saw relatively higher losses in this
year's "severely adverse scenario" due to assumptions of corporate
defaults, a greater decline in stock prices, and higher market
volatility than in past years, Fed officials said in a briefing
with reporters.
Among the biggest banks with large trading operations, Morgan
Stanley and Goldman Sachs were some of the worst performers, with
Tier 1 common ratios dipping to a minimum of 6.2% and 6.3%,
respectively, during the hypothetical scenario.
Fed officials cautioned against drawing any early conclusions
about banks' requested shareholder payouts from Thursday's results,
which assume banks maintain their existing capital plans rather
than including requested changes in 2015 and beyond. In past years,
some banks have included plans to raise capital levels alongside
dividend requests and other actions that would lower capital
levels, they said.
Next week's results will incorporate banks' plans to pay
dividends or purchase shares, moves that will likely lower their
capital ratios below Thursday's results. That could prove
problematic for banks whose capital ratios came close to the Fed's
minimum allowance on Thursday, since a payout could further deplete
that capital buffer.
Goldman and Zions each had a certain capital ratio within
one-tenth of a percent of the Fed's minimum allowance. The Fed
looks at five different measurements of capital at each bank,
including comparing capital levels against a bank's total assets
and against assets weighted by risk.
Banks were told privately by the Fed on Thursday whether their
capital plans would put them below the Fed's minimum threshold in
next week's tests. Any firm in that situation will have a one-time
shot at changing their request for dividends or buybacks. Last
year, Bank of America Corp. and Goldman told the Fed they wanted to
scale back their payout plans after seeing that their leverage
ratio, a measure of equity as a percentage of total assets, had
fallen below the Fed's minimum allowance. Both firms would have
failed the test without making an adjustment.
But strong capital levels don't guarantee banks will get a
green-light to make payouts. As banks have boosted their ability to
absorb severe losses, the Fed has increasingly shifted its focus
toward banks' culture, governance, and ability to assess internal
and external risks. Those "qualitative" factors are now playing a
leading role in the Fed's decision about whether to approve or
reject banks' requests to pay out billions of dollars in dividends
and share buybacks.
Last year the Fed rejected Citigroup, and the U.S. units of HSBC
Holdings PLC, Banco Santander SA and Royal Bank of Scotland Group
PLC for problems related to their ability to measure and predict
risks. The U.S. units of Deutsche Bank AG, which is taking the test
for the first time this year, and Santander are expected to fail
next week due to "qualitative" factors, according to people
familiar with the matter.
The stress tests date to the aftermath of the 2008 crisis, when
they were used to shore up confidence in the U.S. financial system.
This year's test assessed banks holding about 80% of U.S. banking
assets and simulated a substantial weakening in global economic
activity, declines in asset prices, and a large increase in
financial market volatility. The Fed's "severely adverse" scenario
in the U.S. saw unemployment hit 10% in mid-2016, real gross
domestic product fall about 4.5% by the end of 2015 and a 25%
decline in house prices.
The scenario was generally similar to last year's exams, but
reflected regulators' concerns about "leveraged loans" to heavily
indebted companies and included deterioration in the credit of
large corporations. The Fed also assumed a jump in oil prices to
about $110 a barrel--the opposite of what has actually occurred in
oil markets since the scenario was released in October. The Fed
says the results are meant to test banks' resilience, not predict
the future.
By design, the test is harder for the biggest banks. Eight big
firms were forced to contemplate the default of their largest
trading counterparty, and six big trading firms had to show they
could survive a sudden "global market shock."
Thursday's results are supposed to help investors compare banks
with one another, since they don't include future changes in banks'
capital and dividend plans. Several of the largest banks, including
Morgan Stanley and Goldman Sachs, ranked near the bottom in the
Fed's side-by-side comparison of bank capital levels over the
nine-quarter period of severely adverse economic conditions.
Most firms fared better than they did under last year's test,
although about a third fared worse on the Tier 1 common ratio as
compared with 2014, including Goldman, State Street Corp. and Wells
Fargo & Co.
Zions, which failed last year's stress test for a capital
shortfall, had a minimum Tier 1 common ratio of 5.1%, the lowest
among all banks. Deutsche Bank's U.S. unit posted the highest,
34.7%, though Fed officials said the test only covered about 15% of
its U.S. operations. That will change in the future, when the firm
is expected to bring all of its U.S. operations under one holding
company to comply with a separate Fed rule.
Among other large banks, J.P. Morgan Chase & Co. had a
minimum Tier 1 common ratio of 6.5%, Bank of America Corp. fell as
far as 7.1%, Wells Fargo & Co. dropped as low as 7.5%, and
Citigroup fell to 8.2%--equal to the overall average.
Write to Ryan Tracy at ryan.tracy@wsj.com and Victoria McGrane
at victoria.mcgrane@wsj.com
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