The 2015 Bank Stress Tests

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Includes: BAC, DB, FAS, FAZ, FINU, FINZ, FNCL, FXO, IYF, IYG, RWW, RYF, SEF-OLD, UYG, VFH, XLF
by: Value Line

Summary

The Federal Reserve Board’s annual bank stress tests are now five years old.

Most of the participating banks received passing grades in the latest round, but the tests remain somewhat controversial.

The methodology used in the stress tests and the assumptions behind the three hypothetical economic environments used to assess capital adequacy can shift from year to year.

By Theresa Brophy

In March of this year, the Federal Reserve Board announced the results of its fifth round of bank stress tests since the process was initiated in the aftermath of the 2008 financial crisis. A total of 31 financial institutions, representing over 80% of bank assets in the United States, participated in the tests.

The stress tests' purpose hasn't changed since inception. The aim is to gauge whether bank holding companies with $50 billion or more in consolidated assets have sufficient capital to absorb losses, meet obligations to creditors and counterparties, and continue to serve as financial intermediaries during times of financial turmoil. The ultimate goal of the tests is to ensure that bank losses are borne by shareholders, rather than taxpayers.

On the other hand, the methodology used in the stress tests and the assumptions behind the three hypothetical economic environments (baseline, adverse, and severely adverse) used to assess capital adequacy can shift from year to year. In the tests, both the Fed and the individual banks project losses and changes in equity capital under the three scenarios. In its report of the 2015 stress test results, the Fed indicated that the 2015 severely adverse scenario was similar to 2014's, except for the assumption in 2015 that corporate credit quality would worsen more than might be expected in a severe recession.

In fact, the Fed can tailor the test environment with an eye toward current concerns, adding hurdles. For instance, in evaluating the trading portfolios of six banks with large trading and private equity operations in 2015, the Fed assumed a global market shock would occur during the nine-quarter capital planning period (to the end of 2016) and that eight banks with significant trading, processing, or custodial operations would suffer a default by their largest counterparty.

In addition to evaluating capital adequacy, the tests include an evaluation of the quality of the banks' capital plans, that is, whether a bank's plan is reasonable given its individual risks, and whether its capital planning processes are effective. The Fed says it has different expectations for different financial firms, depending on factors like the company's size, activities, and role in the financial system. Banks need to pass this part of the tests to gain permission to pay dividends and/or issue or buy back stock.

So how did the 31 financial companies that participated in the recent stress tests do? As expected, the Fed estimated that the banks would experience significant losses under the most severe scenario, but that the group has strengthened key capital-to-assets ratios meaningfully since the tests debuted in 2009.

In the 2015 stress tests, the Fed gave 28 of the 31 banks the go-ahead to pursue their plans to pay dividends and/or issue or buy back stock. Bank of America (NYSE:BAC) was asked to submit a new capital plan by the end of the September quarter to correct certain weaknesses in its planning process, but was allowed to carry out its plan to buy back up to $4 billion of common stock.

The Fed objected to the capital plans of the U.S. subsidiaries of two foreign banks, Deutsche Bank Trust Corporation (NYSE:DB) and Santander Holdings USA, citing deficiencies in areas like risk identification and measurement, as well as internal controls, in denying the two banks permission to pay dividends and/or buy back stock in the United States.

The stress tests aren't perfect and, as in most years, they were the target of a lot of criticism in 2015. The stress tests have been described as a "black box'' since the Fed doesn't provide much guidance beyond the hypothetical testing environments. It doesn't want the banks to "game'' the tests, that is focus on passing the tests instead of using them as an occasion to take an honest look at the riskiness of their operations and their capital adequacy.

Moreover, when the Fed's projections of a bank's losses or capital ratios and the bank's diverge, it's sometimes hard to know why. Too, there may be some degree of subjectivity in the qualitative portion of the stress tests, in which the Fed assesses the effectiveness of a bank's capital planning processes.

The stress tests have also caused the participating banks in many cases to add hundreds of new hires to prepare submissions, thereby boosting expenses significantly. The Fed itself has built a large examination staff. Bank of America estimates that resubmitting its capital plan to the Fed will add $100 million to expenses in 2015.

Some also point out that the parameters of the severely adverse test environment (in the 2015 tests, a 10% unemployment rate, a 25% decline in home prices, and a 60% plunge in stock prices) are highly unlikely to transpire, calling into question the need for such a costly exercise.

Despite the criticism, participation is no doubt valuable to the extent that the tests heighten the banks' perception of the risks entailed in their businesses. The tests force the banks to take a good look at their capital cushions and take corrective measures if needed. The tests also seem to be playing a larger role in the regulation of the bank industry. While there is certainly room to refine the testing process, we think the stress tests are here to stay.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.