DealBook: Banks Pass Fed’s Tests; Critics Say It Was Easy

Carolyn Kaster/Associated PressBen Bernanke, chairman of the Federal Reserve, at a House panel last month.

9:00 p.m. | Updated

Four years after the financial crisis, federal regulators said that many of the nation’s largest banks were better prepared to sustain future market shocks, paving the way for the healthiest institutions to increase their dividends and buy back shares.

The results of so-called stress tests, released on Thursday by the Federal Reserve, indicate that most large banks would survive a severe recession and a crash in the markets. The tests, which measured a bank’s capital levels during adverse conditions, help validate the government’s efforts to shore up the financial systems.

But some analysts contend that the Fed was still too lenient with the banks. The stress tests, they argue, underestimate potential losses and the effects of several major financial firms collapsing, which can paralyze the entire system.

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“The stress tests were just not very stressful,” said Rebel A. Cole, a professor of finance at DePaul University.

With the industry’s health improving, analysts predict that most big banks will now secure the Fed’s blessing to return money to shareholders, including some unexpected candidates. Citigroup, for example, outperformed its rivals in the test just one year after a poor performance embarrassed the bank and thwarted its plans to distribute capital to shareholders.

This year, Citigroup did not wait long to celebrate. Minutes after the results were released, the bank announced that it asked the Fed’s permission to carry out $1.2 billion in stock buybacks through the first quarter of 2014.

Other banks did not fare as well. Ally Financial, which is majority-owned by the taxpayers since the crisis, burned through nearly all its buffer under the test, which assessed how much capital would remain at the end of 2014 once banks were subjected to hefty losses.

Morgan Stanley and JPMorgan Chase also produced some of the lowest capital results among large Wall Street firms. Goldman Sachs would suffer $25 billion in trading losses under the test. The results were not unexpected; all three firms have significant trading operations that can rack up big losses in turbulent times.

The test results provided an important snapshot of the financial system more than four years after the banking industry was on the brink of collapse. Regulators hailed the industrywide improvements, underscoring what they portend for consumers and the economy.

“The stress tests are a tool to gauge the resiliency of the financial sector,” a Federal Reserve governor, Daniel K. Tarullo, said in a statement. “Significant increases in both the quality and quantity of bank capital,” he said, helps “ensure that banks can continue to lend to consumers and businesses, even in times of economic difficulty.”

Investors will pore over the results, scanning for hints about how much money banks can return to shareholders. After the crisis, regulators prevented lenders like Citigroup and Bank of America from increasing their dividends or repurchasing shares, forcing them instead to hoard capital to absorb losses.

Behind the scenes, the Fed will now signal to each bank whether it can proceed with new payout plans, potentially creating a tense face-off with regulators. If the Fed objects, a bank will have an opportunity to temper its proposals for dividend payments and share buybacks before the plans are released publicly next Thursday.

The stress tests have already caused tension between regulators and banks. The results, which reveal in some detail the losses that banks will suffer under times of stress, prompted wrangling with the Fed over how to conduct the tests and how much data to release.

In another sign of friction, the banks had to run the same test as the Fed — and in some cases produced rosier results. Wells Fargo reported a projected 9.2 percent Tier 1 common ratio, the primary measure of financial strength tracked by regulators, by the end of 2014. That was far higher than the 7 percent calculated by the Fed.

Bank of America’s outlook also trumped regulators’ findings, while Citigroup’s forecast hewed closely to the Fed. Those sorts of discrepancies may feed suspicions that financial firms are overly optimistic about their businesses.

In its overhaul of the regulatory system after the crisis, Congress mandated stress tests to provide an annual health check for the same banks that brought the economy to its knees. The Fed’s tests take banks through a series of adverse conditions, not unlike the last crisis. The tests estimated that 18 banks sustain combined losses of $462 billion, in a period of considerable financial and economic stress in which unemployment soars, stock prices halve and house prices plummet more than 20 percent.

But, to some banking analysts, the tests did not fully capture some forces and events that occur during economic and market shocks. For instance, Wall Street firms may lose access to short-term loans critical to their survival. It is almost impossible to project the impact of the rapid collapse of one or two large financial firms, as in 2008, when Lehman Brothers and American International Group imploded.

Mr. Cole of DePaul said the projected losses on loans appeared too low for the severity of the imagined cases. “If we really had an economic crisis of this magnitude, the loss rates would be at least double on the real estate loans,” he said.

The numbers also show that, over the last year, the Fed has cut its loss projections for certain types of loans. Last year, it projected a 9.5 percent loss rate on Wells Fargo’s mortgages, but this year that dropped to 7.1 percent. The Fed declined to comment on specific banks, but a senior official said lower loss rates were the result of an improvement in the overall quality of the banks’ loan portfolios.

Still, some analysts cheered the results, saying they confirmed the increasing optimism among investors. Bank stocks have risen sharply in recent months, gains that could continue on the heels of the stress tests.

“It’s a very good exercise to do, showing everyone that the U.S. banking system is well capitalized,” said Gerard Cassidy, a banking analyst at RBC Capital Markets.

In a surprise, Citigroup had a projected capital equivalent to 8.9 percent of its assets at the end of 2014, well above last year’s showing. Bank of America’s so-called Tier 1 common capital ratio registered at 6.9 percent, also an improvement.

But Morgan Stanley’s ratio came in at 6.4 percent, temporarily restrained by its purchase of the remaining stake in the Smith Barney retail brokerage joint venture. JPMorgan’s capital levels stood at 6.8 percent. While those banks’ stress test results are lower than rivals, they are still strong capital numbers amid a crisis.

On one important alternative measure of capital, Goldman Sachs had a poor showing compared with its peers. Under the stressed case, the bank’s Tier 1 leverage ratio — another measure of capital strength that treats assets more conservatively — would fall to a low of 3.9 percent.

This could become an issue in any discussions between Goldman and the Fed about the bank’s capital plan. When regulators assess whether a bank can proceed with its capital plan, the Tier 1 leverage ratio cannot fall below 3 percent. Goldman’s own test showed the ratio falling to only 5.1 percent.

Article source: http://dealbook.nytimes.com/2013/03/07/feds-stress-tests-point-to-banks-improving-health/?partner=rss&emc=rss