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Though stress tests are widely viewed as a successful and critical exercise, there are growing concerns that regulators and the banks themselves may have become too reliant on them, overshadowing other aspects of the supervisory process.
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The Fed's annual dissection of each of the 31 largest U.S. banks is a painstaking and enormously complicated endeavor. This is an inside look at how it works.
February 27
WASHINGTON The Federal Reserve Board announced Thursday that all 31 banks that took the Dodd-Frank Act Stress Test this year held enough capital to withstand a severe recession, a positive sign that the industry hailed as proof the days of the crisis are far behind them.
But several of the largest institutions were also teetering on the edge of the leverage and risk-based capital requirements, suggesting that they may have to adopt more conservative capital plans in order to pass the Fed's more comprehensive stress test, the results of which are scheduled to be released on March 11.
Under DFAST, the Fed analyzes the balance sheets of each U.S. bank with more than $50 billion in assets and puts them through hypothetical stress scenarios of varying severity. The DFAST test, unlike the Fed's other stress test, the Comprehensive Capital Assessment and Review, uses a passive capital plan based on a standard formula in order to produce results that are as comparable as possible between banks.
Banks do not technically pass or fail the DFAST test because there is no administrative penalty for falling below the regulatory minimums. However, if a bank falls below the regulatory minimums for the DFAST test, it is a strong indicator that the bank may have trouble passing CCAR, for which there are significant regulatory consequences.
Fed Gov. Daniel Tarullo said in a statement that Thursday's DFAST results indicate that banks overall were better capitalized in 2014 than they were in 2013, noting that the average minimum Tier 1 common capital level under the severely adverse scenario was 8.2%, well above the 5% minimum.
"Higher capital levels at large banks increase the resiliency of our financial system," Tarullo said. "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."
Not all banks emerged from the test unscathed, however. Utah-based Zions Bancorp, which fell to 3.6% Tier 1 common capital ratio in last year's test, squeaked by with 5.1% in the 2014 results, just above the 5% minimum common capital ratio.
Other larger banks were closer to the cut-off for other capital minimums. DFAST and CCAR both assess not the only Tier 1 common ratio but other capital ratios as well, and each bank has to remain above the regulatory minimum in order to pass CCAR. The minimum common equity Tier 1 ratio, for example, is 4.5%. The minimum Tier 1 risk-based capital ratio is 6%, the minimum total risk-based capital ratio is 8% and the Tier 1 leverage ratio is 4%.
Morgan Stanley was within one percentage point of failing the Tier 1 risk-based capital ratio, the Total Risk-Based Capital Ratio and the Tier 1 leverage ratio. The bank posted 6.5%, 8.6% and 4.5% capital in each of those respective categories. Goldman Sachs, meanwhile, only posted 8.1% total risk-based capital in the test, and only posted 6.4% Tier 1 risk-based capital. Citigroup which failed the qualitative CCAR test last year showed a minimum 6.8% Tier 1 risk-based capital and 4.6% Tier 1 leverage ratio.
Indeed, three of the four largest U.S. banks had Tier 1 leverage ratios close to that 4% minimum, with Bank of America at 5.1% while JPMorgan Chase had a 4.6% projected ratio. Wells Fargo fared better on that test, holding a 6.4% Tier 1 leverage ratio.
Still, industry representatives hailed the results, focusing on the relative strength of the common capital ratios as proof that banks are highly capitalized following the financial crisis.
"We're pleased that banks' aggressive efforts to build capital and liquidity over the last five years have enabled them to perform so strongly even under these severe hypothetical stress scenarios," said Frank Keating, president of the American Bankers Association. "Banks' improved capital positions and strong balance sheets should allow institutions to continue meeting customer needs and to pay dividends that help attract investors to fund future growth."
Richard Foster, the Financial Services Roundtable's senior vice president for regulatory affairs, said the results demonstrate that banks are able to withstand any number of upheavals in the global financial system, even if they are hypothetical. Foster said the stress tests could be stronger still if the scenarios used to test the banks were developed in a more transparent manner.
"We remain concerned about the lack of transparency regarding how the Federal Reserve determines financial institutions' scores," Foster said.
One of the outliers of the test was Deutsche Bank, a newcomer to the tests which showed capital levels far in excess of minimum requirements, including a 34.7 Tier 1 common capital ratio. That figure is somewhat misleading, however, because only the bank holding company which represents only roughly 15% of the German bank's U.S. operations was subject to the test.
Many of the largest banks, meanwhile, fared worse than smaller regional banks in the overall Tier 1 common ratios, with nearly all falling at or below the average of 8.2%. A Fed official said that because the severely adverse scenario included a provision that hypothesized an increase in corporate defaults, which put additional stress on capital market assets like corporate bonds, equity markets, and overall market volatility, which accounts for the lower capital ratios.
The official also noted that because DFAST does not take into account a bank's proposed capital management plans, the DFAST results are not necessarily indicative of CCAR results banks can opt to increase their capital holdings as easily as they can opt to buy back stock or issue dividends. But the DFAST results do show that some banks may not have as many options as others to meet both the capital requirements and investors' expectations.
Anna Krayn, director of Enterprise Risk Solutions at Moody's Analytics, said there were "no real surprises" from the DFAST results because the banking system is "very well capitalized, which is well known."
Krayn added that it is difficult to draw substantial conclusions based on the results as well, because they demonstrate only the intersection of a bank's balance sheet and the conditions outlined in the scenarios. It is also reasonable to assume that the scenarios are weighted, at least informally, to bring greater pressure on the larger banks instead of the smaller ones.
"The scenario design, while subject to great care is sort of arbitrary, as far as what gets hit," Krayn said. "On paper everybody's subject to the same requirements, but behind the scenes, the larger banks are subject to greater scrutiny than some of the smaller banks."
Jaret Seiberg, an analyst at Guggenheim Securities, said the DFAST results were a "good news story" for the regional banks and may lend credibility on Capitol Hill to a push to raise the systemically important financial institution threshold over $50 billion. For the larger banks, however, the story may not be as rosy.
"The six mega banks JPMorgan, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley passed the Dodd-Frank test with lower post-severely adverse scenario capital ratios than most of the regional banks," Seiberg said. "Our concern remains that this type of result even though it is explained because these banks are subject to additional shocks could provide support for those who seek even higher capital levels on the biggest banks."
