As financial institution stress tests turn three years old, banks and the Federal Reserve have gotten the now two-stage process down to a science—but there could still be some interesting developments in store for the banking sector.
On Thursday, a tally of banks' various capital levels will be announced, and whether those levels meet the Fed's muster. Then next Wednesday, the banks will unveil what that means for shareholder buybacks and dividends. Here's what to watch for in Round One.
This year's crop has 12 new banks participating in the annual stress tests mandated by Dodd-Frank law: BBVA, BMO, Comerica, Discover, HSBC, Huntington, M&T, Northern Trust, RBS Citizens, Santander, Union BanCal, and Zions.
Already, Zions has said that a charge it took related to Volcker Rule nuances would cause it to have to resubmit its capital plan at a later date. Money center banks saw a baptism by fire during their first stress tests as the Fed kept its formula closely guarded and left banks guessing how to reach the benchmarks. Regulators have had a more supportive dialogue with some of the regional and community banks, but foreign-owned institutions may be at a disadvantage.
The 1.52 percent capital level that Ally posted in 2013 was far from the 5 percent expected by the Fed. The disparity came from a nuanced calculation of preferred stock, and led to a war of words between the auto financier formerly known as GMAC and the country's most powerful banking regulator. In September, Ally raised some $1.3 billion in a private stock placement to boost its equity to clear the hurdle. Now, healthy capital levels will be key in the company's forthcoming IPO, expected within weeks.
Banks will have to pass two benchmarks: a "quantitative" benchmark—the levels for which the Fed has clearly laid out for the banks, even if it has been less forthright in how it calculates those levels; and a "qualitative" test, which measures the extent to which the banks' various risk preparation processes are up to snuff for another financial crisis.
Last year, the Fed said JPMorgan Chase and Goldman Sachs did not meet all the qualitative requirements and had to resubmit their plans. Any banks that miss on the "qualitative" front may yet be able to buy back stock but will suffer a black eye in the process.
In July, the Fed and other regulators introduced a comprehensive leverage ratio aimed at curbing the amount of debt banks take on to fuel trading and other activities. While the leverage ratio was introduced last year as an exercise, banks' ability to meet that hurdle this year will be a sign of their ability to meet expectations when it gets fully implemented in 2015.
According to regulators, multibillion-dollar payouts over legal issues may not be a one-time thing. For the first time, the Fed is expected to add an extra layer of difficulty to the "adversely stressed" scenario in addition to Depression-like unemployment levels and plummeting housing prices: litigation risk. At this point, the country's largest banks have paid tens of billions of dollars to settle crisis-related legal issues. How will the Fed calculate outsized legal risk, and which banks will that endanger?