BAC, C, JPM, WFC: Fed Stress Test and CCAR 2015 Preview

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Spring in America has a new tradition since the end of the ’08-’09 financial crisis. The Federal Reserve’s annual stress tests for systematically important financial institutions is an annual check-up on the health and well-being of America’s biggest banks. Each year the Federal Reserve’s Board of Governors creates a supervisory baseline, adverse and severely adverse economic scenarios, to evaluate bank performance under stressful conditions and to guide bank holding companies in creating their own internal stress tests. The Fed then estimates what would happen to bank revenues, losses, reserves and capital ratios under each scenario.

The baseline scenario is an average of economic forecasts sampled by the Fed. The adverse scenario for 2015 is characterized as a sudden increase in short and long-term US Treasury rates as a result of global economic weakness and inflationary pressures in the domestic US economy. The severely adverse scenario is “substantial weakening” accompanied by “large reductions” in asset prices.

The stress tests are focused on bank holding companies that have greater than $50 billion in assets. The list of companies deemed systematically important has continued to expand with each annual renewal. The Fed focuses on the stress tests because the health of the financial system is increasingly concentrated into the largest bank holding companies. The big survivors of the financial crisis: JPMorgan Chase & Co.(NYSE:JPM), Bank of America Corp (NYSE:BAC), Citigroup Inc (NYSE:C), Wells Fargo & Co (NYSE:WFC) command an overwhelming share of banking assets.

To illustrate how severe of a scenario the Fed is going to model for 2015, last year the ‘severely adverse’ period saw losses in equities of 50% and a decline of 25% in home prices. Last year’s merely ‘adverse’ scenario saw stock losses of 36% with unemployment rising to 9.5% percent with inflation over 2%. One has to reflect a moment with stocks near all-time highs today and recognize the Fed is going to model a near repeat of the financial crisis to see if the biggest banks can survive without help.

The Fed evaluates the banks on their Tier 1 Capital Ratio. The ratio is meant to quantify the amount of equity capital the bank has to absorb losses in their balance sheet. The threshold for passing is 5% and in 2014 only Zions Bancorporation failed, out of 30 banks. Bank of America passed with 6%, but was later forced to correct their results and change their dividend and buy back plan due to an error in loss reserves from assets acquired from Merrill Lynch.

Citigroup failed the stress test for qualitative reasons, despite demonstrating enough Tier 1 Capital. They were cited for a lack of control and transparency of their international operations. JPMorgan and Wells Fargo had 6.7% and 8.2% of project Tier 1 Capital respectively.

Tier 1 Capital Ratios

Bear in mind that this is the Tier 1 Capital ratios after a 50% decline in stocks. The banks have, and maintain, higher capital ratios. Bank of America reported 10.9% last year and reported 12.3% in their annual report filed last week. Citigroup reported 10.59% last year and 10.58% this year. JPMorgan is at 10.2% versus 10.7% prior. Well Fargo reports 11.04% versus 10.82%.

Only Bank of America demonstrates a material change worth noting while Citigroup’s low ratio is likely to face close scrutiny again this year in concert with previous criticisms about operational transparency. Last year, Bank of America was embarrassed after it’s aggressive dividend increase and buyback were undercut by an error in their stress tests. The boost in capital is expected to see them clear the hurdle easily and likely follow through on their plans from last year to boost dividends and buybacks.

Meanwhile, Citigroup looks set to fail again this year unless it demonstrates a better handle on it’s international exposure. In policy discussions, the Federal Reserve has begun to take a critical eye to emerging market exposure as part of their evaluations in determining an increase in the Fed Funds rate. No doubt they will look at all four banks international operations with a critical eye. JPMorgan and Wells Fargo look set to pass the stress tests without note. However, were JPMorgan to surprisingly fail, it would add significant credibility to calls for the bank to be broken up into constituent parts; a plan that was recently rebuffed by senior management for the inefficiencies it would create in the separated entities.

One thing is clear, the quest to break up the ‘Too Big to Fail Banks’ is indefinitely on hold. Congress has acted to restrictively monitor bank operations and capital ratios in lieu of dismantling the banks that pose systematic risks to the economy. The big four banks look set to continue to consolidate their hold on American banking and to serve their existentially critical functions to the U.S. and global economy.

Stress Tests and CCAR Results

The Federal Reserve Board will release  results from the latest supervisory stress tests conducted as part of the Dodd-Frank Act  on Thursday, March 5, and the related results from the Comprehensive Capital Analysis and Review (CCAR), will be released on Wednesday, March 11.  Results for both exercises will be released at 4:30 p.m. EST.

Ross Greenspan

Ross Greenspan is an independent trader and private investor based in
the Chicago area.

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