Results of This Year’s First Round of Stress Tests Were Mostly as Expected

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The Federal Reserve on Friday released the results of this year’s annual Dodd-Frank Act stress test (DFAST), which evaluates the capital of the country’s top 30 banks and measures their ability to continue lending during an economic downturn. The scenario analytics tests were designed to determine if the financial institutions would be able to withstand dire conditions such as a severe drop in housing prices, 11.25 percent unemployment, as well as equity prices overall dwindling by half.

As expected, 29 of the 30 banks tested passed the first round of the Fed’s annual examination of their financial health and stability. These marks were awarded despite this year’s significant new changes that made the rigorous process more complex than in the past. For the first time, 12 medium-sized banks were evaluated along with the larger institutions, as well as the introduction of the Fed’s “severely adverse” and litigation scenarios to determine whether the top six banks (JPMorgan, Citigroup, Bank of America, Wells Fargo, Morgan Stanley, and Goldman Sachs) could handle extreme domestic and international situations.

While the Fed speculated that the banks overall would lose $501 billion if faced with a severe recession and $355 billion in a less dire situation, they also concluded that the system overall is healthier and better equipped to handle a catastrophe than it was five years ago, when testing began. The only institution to fail the DFAST was Zions Bancorporation of Salt Lake City, falling below the 5 percent minimum Tier 1 threshold at 3.5 percent.

This was not a surprise, as the lender had already indicated that it would be resubmitting its 2014 capital plan for evaluation. All the other banks that were examined exceeded the Fed’s standards, paving the way to allow the institutions to pay back investors. Of the large banks, the top performers were New York Mellon and State Street, while the lowest ranked were Morgan Stanley, JPMorgan, and Bank of America. Bank of America had the worst outcome of the large banks, just passing at 6 percent.

The results announced Friday were the first of two reports that will be released this month, with the more uncertain Comprehensive Capital Analysis and Review (CCAR) outcomes expected March 26. While high marks on the DFAST signifies a bank’s ability to stay afloat, the CCAR evaluates each bank’s capital plan and its ability to be both profitable and maintain dividends during an uncertain economic outlook.

Each bank’s CCAR standards are individualized according to the institution’s balance sheet, risks, and assets, as well as its ability to pay excess capital to investors under the same adverse scenarios as put forth in the DFAST. Only after passing both tests will the Fed permit the banks to pay their investors almost $75 billion of excess capital in the form of dividend and buybacks that have accrued since 2009. Needless to say, it’s the CCAR results that the market is anticipating more.

Although Friday’s news held no surprises, next week’s results are somewhat more uncertain. There will be a greater focus on the lowest-ranking institutions, especially JPMorgan and Goldman Sachs, which each had to resubmit their capital plans last year. Insiders will also be paying attention to Citi’s CCAR results due to its low marks, at 7 percent, as well as February’s discovery of $360 million lost due to receivables fraud by a Mexican subsidiary, which forced Citi to resubmit its fourth-quarter financials.

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