The Comprehensive Capital Analysis and Review (CCAR) has become the most important regulatory tool in the Fed's arsenal. It is now the binding capital constraint placed on the large U.S. banks. The significance of CCAR should not be under-estimated by investors - in very basic terms, CCAR governs the amount of capital large U.S. banks can return to shareholders in the form of buybacks and dividends. For Bank Of America (NYSE:BAC) investors - it is all about respectable dividends.
The CCAR process consists of both a quantitative and qualitative tests.
The quantitative test is designed to stress-test the banks' balance sheets in extreme financial scenarios. The banks than need to demonstrate that they hold sufficient capital to withstand extremely challenging financial settings (think along the lines of the 2008/2009 financial crisis or 1930's type of depression).
Given the amount of capital the banks hold in a post-crisis regulatory world - BAC and most of the other banks generally pass the quantitative test with ease - it is normally the qualitative test that gets them!
The qualitative test is clearly much more of a subjective assessment and the banks never quite know to what standards they will be held. This is of course by design and the Fed, quite intentionally, is keeping mum around the details of its assessment methodology. The banks are kept constantly on their toes and there is an in-built expectation for the banks to raise their game. The Fed of course continuously raises the bar to ensure the banks do not get too comfortable and start "gaming" the process. The Fed knows it too well - once you provide bankers with a clear rules book, they will find a way to work around these - it is in their DNA, that's how bankers make a living. In other words, don't expect leopards to change their spots.
So how does the Fed make the qualitative test achieve its desired outcome?
When I refer to the Fed's "desired outcome" - what I really mean is, how does the Fed put the fear of god in the large banks' top executives?
Yes, the masters of the universe do fear CCAR.
The Fed's modus operandi is abundantly clear - identify an important bank and make an example of it. In 2014, it was Citigroup that was delivered a spectacular qualitative fail grade (and Mr. Corbat barely survived it) whereas in 2015 it was BAC's turn with a conditional approval requiring a resubmission.
A brief personal anecdote, if you allow me - this reminds me of certain time in my past corporate life, where I had been tasked with a new role managing a large team consisting of individuals with even larger egos. I was deeply concerned that I would face insurmountable challenges asserting my authority over the team's direction. I turned to my father (and mentor) for some advice. My father immediately quipped:
Sack someone important on the first week - it will work like a charm
In a sense, the Fed tactics are not that different.
Why is CCAR so important?
It is a simple equation - BAC can deliver solid financial results but as long as it cannot return a meaningful proportion of these earnings to shareholders - investors will apply a material haircut to its valuation.
BAC Price to Tangible Book Value data by YCharts
So what could cause BAC to fail CCAR in 2016?
There are several potential causes that may result in BAC failing the qualitative test:
- The negative rates scenarios in the stress tests pose significant operational and technical challenges. The U.S. banks' systems are not currently designed for negative rates environment. BAC is likely to be most impacted given its interest-rate sensitive balance sheet cross the term structure and lesser experience with negative rates scenarios compared with U.S. banks that have more extensive operations in Europe and Japan [e.g. Citigroup (NYSE:C)]. The Fed may identify qualitative issues relating to BAC's ability to forecast accurately its earnings in a negative rates environment.
- While the Fed approved BAC's re-submission of CCAR in December 2015 - it also provided a warning that BAC still needs to show "steady, demonstrable progress." - did management do enough to meet the Fed's raised expectations in 2016?
- The rhetoric employed by Mr Moynihan is somewhat more critical of the Fed than some of its peers (notably Mr. Corbat and even Jamie Dimon). In a recent conference, BAC's CEO stated that the CCAR process is reducing lending in the real economy - these type of tactics are not without risks, the Fed may assume that Mr. Moynihan just doesn't get it (i.e. internalize the post-crisis regulatory intrusions as BAU).
I should clarify - all in all, I believe there is a low probability BAC will fail the 2016 CCAR test (less than 20 per cent). Having said that, it is not without risk.
If the Fed is looking to make an example of one of the large U.S. banks - unfortunately, BAC is probably the prime target. I am certain the next week or so will probably be nerve-wracking for Moynihan and team.
If it is not a clean pass - I am afraid current management will need to go.
Disclosure: I am/we are long BAC, C.
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.