Stress Test 2016: Fed Says All 33 Banks Can Surive 70 VIX Without Needing Outside Capital

While hardly coming as a surprise to anyone, moments ago the Fed announced that all 33 banks have enough capital to withstand a severe economic shock, though Morgan Stanley trailed the rest of Wall Street in a key measure of leverage, Bloomberg reports. The biggest bank cleared the most severe scenario handily, with the exception of Morgan Stanley whose projected 4.9% leverage ratio tied for last place alongside a Canadian bank’s U.S. unit, falling within a percentage point of the 4 percent minimum. As a result of today's "test result" many banks will likely win regulators' approval next week to boost dividends.

From the Fed:

The most severe hypothetical scenario projects that loan losses at the 33 participating bank holding companies would total $385 billion during the nine quarters tested. The "severely adverse" scenario features a severe global recession with the domestic unemployment rate rising five percentage points, accompanied by a heightened period of financial stress, and negative yields for short-term U.S. Treasury securities.

 

The firms' aggregate common equity tier 1 capital ratio, which compares high-quality capital to risk-weighted assets, would fall from an actual 12.3 percent in the fourth quarter of 2015 to a minimum level of 8.4 percent in the hypothetical stress scenario. Since 2009, these firms have added more than $700 billion in common equity capital.

 

"The changes we make in each year's stress scenarios allow supervisors, investors, and the public to assess the resiliency of the banking firms in different adverse economic circumstances," Governor Daniel K. Tarullo said. "This feature is key to a sound stress testing regime, since the nature of possible future stress episodes is inherently uncertain."

 

Capital is important to banking organizations, the financial system, and the economy because it acts as a cushion to absorb losses and helps to ensure that losses are borne by shareholders. The Board's stress scenario estimates use deliberately stringent and conservative assessments under hypothetical economic and financial market conditions. The results are not forecasts or expected outcomes.

Last years was the first time that all banks cleared the Dodd-Frank test without sinking below the minimum capital thresholds. Two banks, one of Deutsche Bank AG’s U.S. units and Banco Santander SA’s U.S. arm, failed the more demanding CCAR assessment and Bank of America Corp. had to resubmit a plan that demonstrated improved risk controls and capital planning.

The Fed's annual confidence boosting exercise is now a tradition ever since the 2008 meltdown; in prior years a few banks have "failed" and were forced to build up capital or withhold dividends. The exams subject banks to Fed-invented hardships and are the cornerstone of the regulator’s efforts to ensure lenders can sustain another financial crisis. The results announced Thursday will be followed next week by the Fed’s release of a more closely watched measure that determines whether banks can make proposed payouts to shareholders. 

“The nation’s largest bank holding companies continue to build their capital levels and improve their credit quality, strengthening their ability to lend to households and businesses during a severe recession,” the Fed said in a statement.

In this year's scenarios the Fed told the for banks to assume - in the most severe case - that U.S. unemployment doubled to 10% while the markets tumbled and Treasury yields went negative. The banks would have experienced resulting loan losses of $385 billion, according to the Fed. In a lesser “adverse” event, the banks contemplated a minor U.S. recession and mild deflation, while a third was a baseline that tracked the average projections of economists. The scenarios also included some extra hardships for big trading firms, as they had to assume market shocks and trading-partner woes on top of the other troubles.

Two of the forecast assumptions - unemployment and VIX - are laid out below. Yes, according to the Fed all 33 "stressed" banks can weather VIX at 70 without needing a dollar in outside funding.

 

More of the details from the severly adverse scenario:

The severely adverse scenario is characterized by a severe global recession accompanied by a period of heightened corporate financial stress and negative yields for short-term U.S. Treasury securities. In this scenario, the level of U.S. real GDP begins to decline in the first quarter of 2016 and reaches a trough in the first quarter of 2017 that is 6.25 percent below the pre-recession peak. The unemployment rate increases by 5 percentage points, to 10 percent, by the middle of 2017, and headline consumer price inflation rises from about 0.25 percent at an annual rate in the first quarter of 2016 to about 1.25 percent at an annual rate by the end of the recession.
Asset prices drop sharply in the scenario, consistent with the developments described above. Equity prices fall approximately 50 percent through the end of 2016, accompanied by a surge in equity  market volatility, which approaches the levels attained in 2008. House prices and commercial real estate prices also experience considerable declines, with house prices dropping 25 percent through the third quarter of 2018 and commercial real estate prices falling 30 percent through the second quarter of 2018. Corporate financial conditions are stressed severely, reflecting mounting credit losses, heightened investor risk aversion, and strained market liquidity conditions; the spread between yields on investment-grade corporate bonds and yields on long-term Treasury securities increases to 5.75 percent by the end of 2016.
As a result of the severe decline in real activity and subdued inflation, short-term Treasury rates fall to negative 0.50 percent by mid-2016 and remain at that level through the end of the scenario. For the purposes of this scenario, it is assumed that the adjustment to negative short-term interest rates proceeds with no additional financial market disruptions. The 10-year Treasury yield drops to about 0.25 percent in the first quarter of 2016, rising gradually thereafter to reach about 0.75 percent by the end of the recession in early 2017 and about 1.75 percent by the first quarter of 2019

As Bloomberg adds, in the first phase -- the Dodd-Frank Act Stress Tests -- measures banks’ capital over the next nine quarters, assuming they will continue paying current levels of dividends and won’t repurchase stock. The next phase -- the Comprehensive Capital Analysis & Review, or CCAR -- slated for June 29 evaluates whether firms can increase dividends and buy back shares. Leverage proved a tough hurdle for a number of companies in the first phase, with the U.S. unit of Bank of Montreal tying with Morgan Stanley for the lowest projected level. State Street Corp. was seen dropping to as little as 5.4 percent, with Bank of New York Mellon Corp. at 5.5 percent, according to the Fed. Huntington Bancshares Inc., based in Columbus, Ohio, ranked last on three capital measures.

Now that banks have the first part of their results, they have an opportunity to revise the capital plans they sent to regulators before CCAR comes out. Those who think their capital-distribution strategies may have been overambitious can send a new version, as JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley did last year.

Earlier this week, Janet Yellen said in congressional testimony this week that the stress-test process is about to undergo “meaningful changes.” She underlined plans recently announced by Fed Governor Daniel Tarullo that would impose a higher capital target on eight of the largest firms, while giving mid-size banks a break from CCAR assessments of whether lenders adequately track their market risks.

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The full report is below: