US banks pass first round of annual stress tests

US banks have big enough capital buffers to keep trading through an economic meltdown, regulators said on Thursday, in a finding that improves their chances of boosting payouts to shareholders.

In the first round of this year’s stress tests, the Federal Reserve probed how 34 banks would fare in a financial and economic slump in which the unemployment rate doubles and the stock market loses half its value. The central bank calculated that the banking sector would endure $493bn in losses in the simulated downturn.

Yet officials concluded that the banks would emerge from the crash “well capitalised”, with cushions of shareholder funding still above the Fed’s minimum required levels.

The largely upbeat results augur well for US banks as the Fed prepares to unveil the results of the tests’ second round next week, when investors will learn how much capital they can return through dividends and share buybacks.

However, the figures released on Thursday do not foretell what the Fed will say about payouts, not least because regulators can approve or block US banks’ capital plans on qualitative as well as quantitative grounds.

UBS analysts estimate that the four biggest by assets — JPMorgan, Bank of America, Citigroup and Wells Fargo — will be able to return a net $59.8bn this year, rising to $72.3bn in 2018.

Citi and Morgan Stanley could be among about a dozen banks that will make requests to return more than 100 per cent of their annual earnings to shareholders, according to Goldman Sachs analysts.

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Despite the positive stress test results, not all investors would be comfortable with such a bonanza. Bill Hines, a fixed-income investment manager at Aberdeen Asset Management in Philadelphia, said the prospect of payouts in excess of profits “does scare us a little bit”.

“If the safety blanket is pulled away . . . that may come to the detriment of capital and safety.”

Across-the-board passes for the stress-test are “a good thing,” he said, as it shows that banks have rebuilt capital levels substantially since the crisis. “But from a creditor’s standpoint you don’t want to see all the profits go out the door.”

While banks have already told the Fed what they propose to do on dividends and buybacks, they are now able to make more conservative payout plans if, based on the first-round results, they think it will reject them in the second round.

The regulator’s simulated downturn lasts for nine quarters. Banks’ overall loan losses and declines in capital under the worst crisis scenario were smaller than in last year’s stress tests, Fed officials said.

Still, the test found that some banks would come close to breaching regulatory minimums during the meltdown on some metrics. For instance, Morgan Stanley’s “supplementary leverage ratio” — a new measure of financial strength that takes effect in 2018 — would drop as low as 3.8 per cent compared with a required level of 3 per cent.

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The results also drew attention to banks’ exposure to credit card lending. The Fed found banks would suffer the biggest losses in their card portfolios in the hypothetical crisis.

Fed officials said that partly reflected a rapid expansion in the size of banks’ credit card assets and rising delinquency rates in the real world.

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