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Banks Breeze Through Fed's Annual Stress Tests

Results of adverse scenarios are generally in line with Morningstar's own Stress Test analyses.

Late on March 5, the Fed released the results from the supervisory stress tests conducted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This year, the stress test differed from prior years in that the Federal Reserve used two scenarios, "adverse" and the newly added "severely adverse" scenarios, with the latter characterized by a substantial global weakening in economic activity, including a severe U.S. recession, large reductions in asset prices, significant widening of corporate bond spreads, and a sharp increase in equity market volatility. All 31 of the banks subject to the stress test passed as the minimum of their Tier 1 common ratio stayed above 5% under both the severely adverse and adverse stress-case scenarios. The results are no surprise to us as they are generally in line with Morningstar's own Stress Test analyses.

The Fed noted in its press release that for all 31 banks as group, the cumulative loss rate for all accrual loan portfolios is 6.1% over a nine-quarter period, lower than the loss rate from the 2014 DFAST, or Dodd-Frank Act Stress Test. As stated in the Federal Reserve's press release, this reflects a "continuing a trend of declining loan loss rates under the severely adverse scenario over time, as borrower and loan characteristics have continued to improve."

We also are interested to see that estimated losses relating to trading activities and large counterparty failures were manageable across the universe of large banks (public information on individual counterparty exposures is scarce), equaling $55 billion this year under the adverse scenario--just under the $57 billion in estimated losses last year. Under the severely adverse scenario, estimated losses totaled $103 billion.

Next on the calendar for the Fed is the March 11 release of the results from the Comprehensive Capital Analysis and Review. The CCAR takes into account each company's capital plans, such as dividend payments, stock repurchases, or planned acquisitions, along with a qualitative assessment of the bank's capital planning process. The Fed basically evaluates whether each bank would still pass the stress test even after planned capital releases.

We think the capital return plans of the U.S. banks we cover will be accepted by the Fed, given these banks' experience with the process. We're more concerned, however, about  Deutsche Bank (DB), which is entering the process for the first time in 2015. In 2014, non-U.S. banks in their first go-around with the tests fared poorly-- Banco Santander (SAN),  HSBC (HSBC), and  Royal Bank of Scotland's (RBS) capital return plans were rejected by the Fed on qualitative grounds.

In fact, we would not be surprised to see certain companies approved for significant dividend increases at that time. Given that all companies would maintain adequate capital buffers under a severely adverse scenario, we think firms with exceptionally low payout ratios like  Bank of America (BAC) and  Citigroup (C) could easily boost payout assuming their qualitative processes have improved. We also think the exceptionally high capital levels of  American Express (AXP) and  Discover (DFS) would allow these firms to boost buybacks or dividends. 

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Dan Werner does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.