Big Banks Pass Muster in Latest Stress Tests

The nation’s largest banks appear to have the financial strength to survive a nightmarish world where unemployment soars, house prices plummet and Wall Street crashes, the Federal Reserve said on Thursday.

The Fed requires big banks to undergo “stress tests” each year that aim to assess whether the institutions would be able to withstand the sort of economic and financial storm that ripped through the country more than six years ago.

Put simply, the tests add up the losses that a bank would suffer on its loans and trades during the hypothetical storm. The Fed then assesses the degree to which those losses would deplete a bank’s capital, the financial foundation of every bank.

Some of the 31 banks in this year’s test would emerge from the theoretical shocks with significantly less capital than others.

Under the tests, Goldman Sachs fell very close to a minimum requirement for one measure of capital. This may put the firm in the awkward position of having to reduce the amount of money that it had planned to pay out to its shareholders this year. Zions Bancorporation, a regional bank that fared poorly in last year’s tests, also fell very close to a minimum level.

Bank of America was well above all the minimum requirements, putting it among Thursday’s clear winners.

Unlike last year’s test, this one showed no bank with capital below the minimum, a result that might provide comfort to the Fed as it seeks to make the financial system stronger.

“Higher capital levels at large banks increase the resiliency of our financial system,” Daniel K. Tarullo, the Fed governor who oversees regulation, said in a statement. “Our supervisory stress tests are designed to ensure that these banks have enough capital that they could continue to lend to American businesses and households even in a severe economic downturn.”

The Fed projected that the 31 banks would suffer losses of $490 billion during a period of just over two years, under its most severe assumptions. Those include a deep recession in which the unemployment rate reaches 10 percent. In addition, the stock market falls by more than half and house prices lose a fourth of their value.

But the results on Thursday represent only the first stage of the tests.

In many ways, the second stage is more important to the banks. Next Wednesday, the banks will find out if the Fed has approved their plans to distribute capital to shareholders through dividends and stock buybacks. Banks that fell close to minimum capital levels on Thursday may have to scale back their requests to pay out capital to avoid going below the minimum thresholds.

The Fed, however, may also object to a capital payout request if it judges that a bank has not participated in the stress tests with sufficient thoroughness.

When the Fed objects to a capital payout plan, the bank is deemed to have failed the stress tests.

Last year, Citigroup failed because the Fed objected to the quality of its internal stress testing process. Banks have to carry out their own stress tests, to prompt them to plan for dire events. They released the results of those on Thursday.

stress test

The Fed privately informed the banks on Thursday whether it had objected to their capital payment plans. If a bank fails because its proposed capital payment might take its capital below a minimum threshold, it can offer to reduce the payments.

Goldman Sachs scaled back its request last year. And it may find itself in a similar situation this year. The stress tests detailed on Thursday left the bank with “total risk-based capital” equivalent to 8.1 percent of a regulatory measure of Goldman’s assets. The minimum required for that measure of capital is 8 percent.

Likewise, Zions Bancorporation was left with Tier 1 common capital worth 5.1 percent of its assets, slightly higher than the 5 percent minimum. Goldman declined to comment. James Abbott, head of investor relations at Zions, asserted that the bank’s results were substantially better than last year’s. “We will continue to take steps to reduce risk within the company,” he added.

Banks that fared better may not be able to relax, however.

Under the stress tests, Citigroup, JPMorgan Chase and Morgan Stanley all fell below 5 percent when applying a measure of capital known as the “leverage ratio.” But each remained above the minimum of 4 percent. The question now is whether their proposed capital payouts are big enough to take them below 4 percent. Citigroup recently announced plans to issue new preferred stock, so it may have the capacity to make its proposed payments to shareholders.

Right now, though, most of the jitters on Wall Street revolve around the possibility that the Fed will reject capital plans because it believes them to be inadequate.

An American unit of Deutsche Bank, the German bank that has recently come under much regulatory scrutiny, is most likely going to fail for this reason, according to a person briefed on the process. The Deutsche unit had some of the highest capital ratios after the stress test. But the unit represents just a small portion of Deutsche’s American operations.

An overhaul in the way foreign banks are regulated in the United States will subject the other Deutsche businesses to stress tests in the coming years.

The stress tests also underscore an important shift in power within the Fed that took place after the financial crisis.

The reorganization reduced the sway of the Fed’s regional banks, including the Federal Reserve Bank of New York, which traditionally had outsize influence because it oversees the nation’s largest institutions, including JPMorgan and Citigroup. The postcrisis changes effectively put more regulatory power in the hands of the central body of the Fed, known as theFederal Reserve Board. Mr. Tarullo is the board member who steers regulatory policies.

It is the staff of the board, for instance, that draws up the dire models that the banks have to apply in the tests. More important, the board, not any regional Fed entity, votes on whether a bank fails a stress test because its capital planning and testing were judged to be deficient. The board, not the New York Fed, decided that Citigroup had failed last year.

As The Wall Street Journal reported on Thursday, the reorganization was described in an internal paper known as the “triangle document.” The Fed board and the regional Fed banks represented two sides of the triangle, according to a person briefed on the document. The remaining side of the triangle was labeled “quantitative supervision,” a regulatory effort that includes input from both the board and the regional entities, this person said.

Some banking experts are worried that the emphasis on the stress tests might give rise to a false sense of security. In particular, they contend, it is impossible to know what an actual crisis will look like ahead of time. The Fed assumes that large Wall Street firms have to deal with the default of a large trading partner.

“What are they assuming happens in that default? What are they assuming about contagion?” said Anat R. Admati, a professor of finance and economics at Stanford. “It takes a leap of faith to feel safe because of these tests.”


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