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From Banking and Finance Law Daily, March 6, 2015

Stress test results show largest banks improving their capital strength

By Colleen M. Svelnis, J.D.

The largest U.S.-based bank holding companies (BHCs) continued to improve their capital positions, according to the latest stress tests results released by the Federal Reserve Board. On March 5, 2015, the Fed released the “Dodd-Frank Act Stress Test 2015: Supervisory Stress Test Methodology and Results,” which includes hypothetical scenarios to project loan losses. The 31 firms tested represent more than 80 percent of domestic banking assets.

As Federal Reserve Governor Daniel K. Tarullo explained “supervisory stress tests are designed to ensure that these banks have enough capital that they could continue to lend to American businesses and households even in a severe economic downturn.” The severely adverse scenario projected that loan losses would total $340 billion during the nine quarters tested. This is an improvement over the first year of testing, in 2009 where aggregate tier 1 common capital ratio was 5.5 percent as measured.

Background. The quantitative results from the Dodd-Frank stress tests are one component of the Fed’sanalysis during the Comprehensive Capital Analysis and Review (CCAR). This is the fifth round of stress tests led by the Fed since the tests in 2009 and is the third year that the Federal Reserve has conducted stress tests pursuant to the Dodd-Frank Act. The Dodd-Frank Act requires the Fed to conduct an annual stress test of large BHCs and all nonbank financial companies designated by the Financial Stability Oversight Council for Fed supervision.

The Dodd-Frank Act also requires BHCs and other financial companies supervised by the Fed to conduct their own stress tests. Together, the Dodd-Frank Act supervisory stress tests and the company-run stress tests are intended to provide company management and boards of directors, the public, and supervisors with forward looking information to help gauge the potential effect.

Large, complex bank holding companies are required to have sufficient capital to continue lending to support real economic activity while meeting their financial obligations, even under stressful economic conditions. Stress testing is one tool that helps bank supervisors measure whether a BHC has enough capital to support its operations throughout periods of stress. "Higher capital levels at large banks increase the resiliency of our financial system," said Tarullo.

Severely adverse scenario. The most severely adverse scenario shows a deep recession with an unemployment rate of 10 percent, a decline in home prices of 25 percent, a stock market drop of nearly 60 percent, and a rise in market volatility. Projections include:

  • loan losses would total $340 billion;
  • aggregate tier 1 common capital ratio would fall from an actual 11.9 percent in the third quarter of 2014 to a minimum level of 8.2 percent in the hypothetical stress scenario;
  • $340 billion in accrual loan portfolio losses;
  • $18 billion in other than temporary impairment (OTTI) and other realized securities losses;
  • $103 billion in trading and/or counterparty losses at the eight BHCs with substantial trading, processing, or custodial operations; and
  • $29 billion in additional losses from items such as loans booked under the fair-value option.

By comparison, in 2014, projected loan losses were $366 billion and aggregate tier 1 common capital ratio was projected to fall from an actual 11.5 percent in the third quarter of 2013 to the minimum level of 7.6 percent.

Adverse scenario. The adverse scenario features a more moderate recession, but a rapid increase in short- and long-term interest rates. Results showed that aggregate tier 1 common capital ratio of all 31 firms would fall from an actual 11.9 percent in the third quarter of 2014 to the minimum level of 10.8 percent. Results included:

  • $235 billion in accrual loan losses;
  • $9 billion in OTTI and other realized securities losses;
  • $55 billion in losses from the global market shock and the largest counterparty default components; and
  • $16 billion in additional losses from items such as loans booked under the fair-value option.

Industry reaction. American Bankers Association President and CEO Frank Keating released a statement saying the “banks’ improved capital positions and strong balance sheets should allow institutions to continue meeting customer needs and to pay dividends that help attract investors to fund future growth.”

“With total industry capital now over $1.7 trillion, banks are well positioned to continue serving as a critical driver of our economic growth going forward,” Keating said.

In response to the stress test results, Financial Services Roundtable’s Senior Vice President and Senior Counsel for Regulatory and Legal Affairs Richard Foster noted that “While we remain concerned about the lack of transparency regarding how the Federal Reserve determines financial institutions’ scores,” he said the stress test results “show the financial industry remains a strong and secure driving force for the growth of the nation’s economy and American jobs.”

Companies: American Bankers Association; Financial Services Roundtable

MainStory: TopStory BankHolding BankingOperations DoddFrankAct FederalReserveSystem FinancialStability

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