US bank stress tests: 4 things to watch

Alistair Gray
Juanmonino | Getty Images

The amount of cash big US banks distribute to shareholders is no longer a matter only for their boards. Since the 2008 financial meltdown, regulators have had a veto under the stress test regime which is designed to prevent another crisis. On Wednesday the Federal Reserve reveals which banks have got the thumbs up for planned capital returns for the year ahead. Here are the big questions investors want answered.

How much cash will shareholders get their hands on?

The results of the stress tests' first round, published last week, confirmed that all 34 banks examined would have enough capital to absorb losses during a time of extreme financial difficulties without burdening the taxpayer. Moreover, according to Evercore ISI, for all but six of them the margin of safety above required capital levels was higher than in the previous year.

The findings bode well for the level of dividends and share buybacks, determined by the more consequential second round. Several analysts predict a capital bonanza. The big six — Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, JPMorgan Chase and Wells Fargo — should be able to distribute a net $78.9bn in total, estimate KBW analysts, a rise of about a third from a year ago.

Receive 4 weeks of unlimited digital access to the Financial Times for just $1.

Still, investors face an anxious wait on Wednesday. The results of the first round last week do not guarantee the outcome of the second, in part because they did not incorporate individual banks' capital return plans.

Will Wells Fargo fail?

In keeping with its post-crisis image as one of the country's best run banks, Wells Fargo breezed through previous stress tests. But its reputation nosedived last year when the bank became embroiled in a huge scandal. Employees fraudulently set up hundreds of thousands of fake accounts for unsuspecting customers.

The fallout has already cost the bank its status as the world's most valuable and now Wall Street is worried it could put the kibosh on planned shareholder payouts.

Although Wells Fargo did well on the first, quantitative part of the stress tests this year, in the second round the Fed can block capital return plans for "qualitative" reasons — how well the bank is governed and manages risks.

To pass, Wells will need to convince the Fed that the sales scandal has been contained and that the subsequent steps it has taken — shaking up senior management, strengthening whistleblower protections, and so on — are adequate.

A survey by Goldman Sachs analysts published this month found that more than 50 per cent of investors believe the bank will fail. Such an outcome would be a big blow for recently appointed chief executive Tim Sloan and suggest the bank still has deep-rooted problems.

Who else could be tripped up by the 'qualitative' test?

In previous years, some banks have scored highly in the first round of the Fed's exercise only to come unstuck by the second part's "qualitative" test.

Citigroup failed three years ago because the regulator was concerned about the "overall reliability" of its "capital planning process", putting pressure on chief executive Michael Corbat. The bank subsequently made a big compliance push and got the regulatory thumbs up in the past two years.

The biggest losers more recently have been American offshoots of foreign banks: Spain's Banco Santander has flunked the test for three consecutive years and a US operation of Deutsche Bank for two. They will be spared such embarrassment this time, however. The Fed has dropped the "qualitative" part of the test for smaller US lenders and several foreign groups, totalling 21 of the 34 banks.

How big a constraint is the new capital standard?

For the first time this year, the Fed is testing the biggest banks on a new measure of financial strength — the so-called supplementary leverage ratio (SLR).

The measure is a blunt, catch-all metric devised as part of the global Basel III reforms to pick up on threats to banks not covered by the other four capital measures used in the stress tests.

The calculation is regarded as tough because it includes off balance-sheet exposures and also prevents banks from assigning less capital to activities deemed to be lower risk. It is seen as particularly tough for custodians and some investment banks.

In the first round of the stress test last week Goldman Sachs, Morgan Stanley and State Street came within a couple of percentage points of breaching required SLR levels. That could limit the amount of capital they are able to distribute.

Analysts believe they might need to take what is known as the Mulligan, after the golfing term for taking another swing. Banks have already submitted capital return plans to the Fed, but they can make more conservative payout plans if, based on the first-round results, they think regulators will reject them.

More from the Financial Times:
The internet of things: industry's digital revolution
Brexit set to blow hole in common EU budget, Brussels warns
Cabinet tension on Brexit breaks out into the open