Last Thursday, the US Federal Reserve published the results of the 2017 Dodd-Frank Act stress test (DFAST) for 34 of the largest US bank holding companies (BHCs), all of which exceeded the 4.5% minimum required common equity Tier 1 (CET1) capital ratio under the Fed’s severely adverse stress scenario, a credit positive.
This is the third consecutive year that all tested BHCs exceeded the Fed’s minimum requirement, and the median margin above the minimum also increased. However, for the first time, this year’s test incorporated the supplementary leverage ratio (SLR) for advanced-approach banks, which was more constraining for some of the banks.
DFAST considers how well banks withstand a severely adverse economic scenario, which is characterized as a severe global recession. The 2017 test scenario used modestly more favorable interest rates than in 2016 with a greater increase in rates and no negative short-term rates. The test incorporated a 6.5% peak-to-trough decline in US real gross domestic product, an increase in the unemployment rate to 10%, a 50% decline in equity prices through year-end 2017, and a 25% drop in home prices and a 35% decline in commercial real estate prices by 2019.
All 34 BHCs were subjected to this scenario, including new participant CIT Group Inc. In addition, the stress tests for eight of the 34 BHCs with substantial trading or processing operations were required to incorporate the sudden default of their largest loss-generating counterparty. The eight BHCs subject to the counterparty default component were Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., The Goldman Sachs Group, JPMorgan Chase & Co. Morgan Stanley, State Street Corporation, and Wells Fargo & Company. Finally, six of these eight BHCs with significant trading operations were also required to include a global market shock (Bank of New York Mellon Corporation and State Street Corporation were excluded from this global market shock scenario.)
On 28 June, the Fed will release the results of the Comprehensive Capital Analysis and Review (CCAR), which evaluates the BHCs’ capital plans, including dividends and stock repurchases, incorporating their DFAST results. The capital-planning processes of the large complex banks will also be publicly evaluated. Prior to the CCAR release, BHCs can reduce their planned capital distributions, commonly known as taking a “mulligan.” Our analysis of pre-provision net revenue declines and loan losses under the severely adverse scenario highlights still significant tail risks for DFAST participants. Nonetheless, we expect banks’ capital distribution requests to be more aggressive than in prior years, which will limit or negate improvement in their capital ratios.
ALL BANKS EXCEED MINIMUM REQUIRED CAPITAL IN THE SEVERELY ADVERSE SCENARIO
Exhibit 1 compares the minimum CET1 ratios of 34 participating BHCs under the Fed’s severely adverse scenario with their actual CET1 ratios reported at year-end 2016. The exhibit segments the BHCs into two groups: the 26 BHCs subject only to the severely adverse economic scenario (on the right), and the eight BHCs also subject to the additional global market shock and counterparty default components noted above (on the left). The minimum CET1 ratios of the eight large BHCs are all comfortably above the Fed’s 4.5% requirement despite being subjected to the additional stress components. The other 26 BHCs are also above the 4.5% requirement, although for many the margin is smaller than for the largest BHCs. The lowest minimum ratios were for Ally Financial Inc. at 6.6%, up from 6.1% in the 2016 test; and KeyCorp at 6.8%, up from 6.4% in 2016.
Even though all of the BHCs passed the 4.5% minimum threshold, many would still take sizeable capital hits under the Fed’s severely adverse scenario (Exhibit 2). The estimated declines in the BHCs’ CET1 ratios range from a high of 840 basis points (bp) for Morgan Stanley to a low of 210 bp for Santander Holdings USA, Inc.. Positively, the median of the 34 banks was narrower at 280 bp compared with 350 bp last year, indicating greater overall resilience to an economic shock. In its report, the Fed partly attributed this to lower losses from changes in the banks’ portfolio composition and risk characteristics.
SUPPLEMENTARY LEVERAGE RATIO IS A GREATER CONSTRAINT FOR SOME BANKS
The BHCs’ generally good results for stressed CET1 ratios in DFAST suggests that increased capital distributions are likely for the vast majority of institutions. However, CET1 is not the most constraining ratio for all banks. In particular, this year’s test for the first time incorporated the supplementary leverage ratio (SLR) for the advanced approach banks (Exhibit 3). Because the denominator of the SLR comprises average assets and off-balance sheet exposures, it tends to be much larger than the risk-weighted asset denominator of CET1, with the result that the banks’ margin above the 3% minimum SLR is smaller. Morgan Stanley had the lowest minimum SLR of 3.8%, which is likely to constrain its efforts to return more capital to shareholders. State Street and Goldman Sachs also had comparatively low minimum SLRs.
