The Federal Reserve has released the results of its stress tests under the Dodd-Frank rules (DFAST) for 18 banks. All but Ally Financial would remain above the minimum standard of 5% Tier 1 Common Equity in spite of very adverse circumstances modeled to take place between September 30 2012 and December 31, 2014. The results would not generally support a generous increase in dividends or shareholder buybacks, except for Bank of New York (NYSE:BK), whose capital actually would continue to increase under the terms of the exercise. They will likely engender some selling at the market open as market hopes for returns to shareholders could be disappointed.
Not surprisingly, some of the banks have seen fit to reveal the results of their own stress tests, which are more favorable. The Fed is to opine on the integrity of those tests, and the consequent leeway of the banks to repurchase shares or increase dividends on March 14. On average, the banks' own models would see minimum Tier 1 common equity bottom out at levels about one percentage point higher, at 8.2% rather than 6.9%. Should the Fed accept these results, the returns to shareholders would be substantially more favorable than in the past few years. That is unlikely, however.
Ally Financial Inc.
Bank of America Corporation
Capital One Financial
The Goldman Sachs Group, Inc.
JPMorgan Chase & Co.
The PNC Financial Services
Wells Fargo & Company
Performed under the same broad assumptions required by the Fed, the bank's own projections include the impact of capital actions that the DFAST does not contemplate, and may deviate in how earnings are presumed to react. Ally assumes the conversion of $5.9 billion of debt into equity. Capital One (NYSE:COF) points out the tendency of funding costs to drop in recessions, offsetting some of the losses on credit card loans that are effectively fixed rate, and credit card issuers' great flexibility to cut their substantial marketing costs. Others provide few insights into where their own models may differ from those of the Fed. The reports do point out where the greatest disagreements may be. Namely, the greatest divergence is at Goldman Sachs (NYSE:GS) and Capital One, which believe their capital would bottom out at 8.6% and 9.2%, respectively, rather than 5.8% and 7.4%.
It is indicative that among those that fared best under the stress tests, Citigroup (NYSE:C) revealed that it did not request an increase to dividends from its current nominal $0.01 quarterly rate, and only $1.2 billion of share repurchases over nine months. That does not leave much hope for those that fared worse. It may be too early for the Fed to let up in the capital building trend under way.
The effect of the stress test was hardest on those who are most focused on trading operations. Part of that is the apparent severity of the stress test, and part the transition to Basel 2.5 risk weights for trading assets over the course of the nine months. If the starting point for the comparison had been the fully phased in Basel III capital measures, the differences between the start points and the minimums would be less.
Nevertheless, the exercise raises the prospect of adding another capital regime upon the banks-one that is markedly different in its assessment of relative risks of bank activities than the prospective Basel II regime. It risks raising effective Basel III capital requirements beyond the 8-9.5% Tier 1 common for the GSIFIs. It seems that bank troubles are not over.
Disclosure: I am long GS, JPM, BK, WFC, MS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.