Stress test results show hit to capital from tax reform

Enjoy complimentary access to top ideas and insights — selected by our editors.

WASHINGTON — The largest banks were able to maintain minimum capital levels in the first round of stress tests released Thursday, though some firms took larger losses because of higher credit card balances and one-time accounting challenges related to last year’s tax overhaul.

“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,” said Federal Reserve Vice Chairman for Supervision Randal Quarles.

The Fed issued the results for 35 banks that participated in the Dodd-Frank Act Stress Test in 2018. The tests mandated by the 2010 reform law — known as DFAST — precede a separate round of stress tests results expected next week in the Fed's Comprehensive Capital Analysis and Review.

The Fed added the results of six new banks — Barclays, UBS, Royal Bank of Canada, BNP Paribas, Credit Suisse and DB USA — that are the U.S.-based holding companies for foreign-owned banking giants. DB USA replaces Deutsche Bank Trust, which had been subject to stress testing requirements in earlier years.

Those banks' "intermediate holding companies," or IHCs, performed especially well in terms of capital retention, with Credit Suisse topping the list with 17.6% Common Equity Tier 1 ratio in the severely adverse scenario, or CET1.

UBS Americas followed with 16.4% and Santander with 15.2%. DB USA and MUFG Americas each retained 12.2% CET1 post-stress, while RBC and TD Group each retained 11.2% CET1.

Among U.S. based banks, Northern Trust topped out at 11.7% CET1 post-stress capital. Only a few banks came close to the minimum 4.5% CET1 ratio. State Street’s post-stress CET1 capital was the lowest at 5.3%, while Goldman Sachs’ post-stress capital was 5.6% and Capital One Financial Corp. came in at 5.7%.

However, while every bank passed, their results were not as stellar as last year. Fed officials attributed the larger losses among more complex banks to a combination of higher credit card exposures — a similar trend to what was observed last year — and changes to the tax code enacted by the recent congressional overhaul.

The tax law reduced the value of deferred tax assets, which are meant to offset tax liabilities. With the reduction in those assets’ value, the holder’s starting capital position is commensurately reduced. The law also eliminated some carry-forward and carry-back provisions that had been in the tax code that allowed banks to attribute losses either to earlier or later tax years. The elimination of those provisions makes losses more closely confined to the stress period, reflecting in more severe losses than might have been the case in earlier years.

Three additional banks — Comerica, CIT Group and Zions — participated in the tests but had their results withheld because of the recent regulatory relief bill.

That bill raised the threshold for Systemically Important Financial Institutions from $50 billion to $250 billion, though the Fed can regulate banks between $100 billion and $250 billion at their discretion. Because banks with less than $100 billion are no longer subject to supervisory stress testing, the Fed said in a statement, they will not release those results. However, the central bank said it may modify that approach “at a later date.”

There have been concerns that the new banks may face qualitative challenges in the second round of stress tests, known as CCAR. Those results are scheduled for release June 28.

Since 2011, the Fed has conducted the two separate stress tests each year on all banks with more than $50 billion in assets. Both CCAR and DFAST examine a bank’s balance sheet and use proprietary models to determine how institutions would perform over nine consecutive future quarters under baseline, adverse and severely adverse economic conditions.

Those conditions are developed by the Fed several months before the examinations begin, and the severely adverse scenario — generally the binding constraint in the stress test results — is meant to mimic the conditions of an economic stress event on the order of the 2008 financial crisis.

Each of the banks examined must maintain capital levels at or above the regulatory minimums in several categories — including Tier 1 capital, total capital and leverage ratio — for both DFAST and CCAR, though there is no consequence if a bank fails DFAST. If a bank falls below a capital ratio for CCAR, however, the Fed may instruct the bank not to pay dividends until the minimum capital levels are met. The Fed may also give a bank a failing grade on qualitative grounds, if their risk management or internal models are inadequate, for example.

But the stress tests have begun to evolve in meaningful ways. In January 2017, the Fed decided not to issue qualitative objections for banks with less than $250 billion in assets and less than $75 billion in nonbank assets that are not otherwise designated as Global Systemically Important Banks.

More recently, the Fed has proposed to replace its static minimum capital ratios, applicable to each of the banks, with a formula that includes a “stress capital buffer,” effectively using a bank’s capital losses from the previous year’s stress test as a metric for how much capital it must retain the following year.

The Fed has also proposed giving banks more insight into how its internal models perform — an idea that critics have charged would be tantamount to "teaching to the test" and would water down the stress tests unnecessarily.