Final Test

Aiming to give their shareholders an early boost in 2011, the nation’s largest banks are looking to begin increasing payments on dividends, which have been either suspended or significantly reduced since the onset of the financial crisis in September of 2008. However, the Fed announced today that before any such moves take place amongst the largest U.S. banks, a “number of criteria” must first be met.

Under the guidance issued by the Fed, all 19 of the bank holding companies that participated in the Fed and Treasury-administered “stress tests” in 2009 will be required to submit capital plans—which include a demonstration of a bank’s ability to absorb losses under “adverse” economic conditions and its ability to comply with Basel III capital standards—by early 2011 for the Fed’s review. The capital plans will be submitted to the Fed, regardless of whether a bank plans to either raise dividends or repurchase stock shares. In addition, all government investments in a bank must be repaid or replaced with common or preferred stock before any dividend increases or stock repurchases take place. The Fed said it expects to begin responding to bank requests for such actions beginning in the first quarter of 2011.

The results of the Supervisory Capital Assessment Program (SCAP), or stress tests, which occurred during the spring of 2009 on the nation’s largest bank holding companies to predict “potential losses, the resources available to absorb losses, and the resulting capital buffer needed” based on various economic scenarios, revealed that ten of the 19 participating banks needed to increase their capital buffers for a combined total of $74.6 billion. SCAP was largely credited with boosting market confidence by providing a much-needed certification of the health of each bank’s balance sheet.

Federal Reserve—Revised Temporary Addendum to SR letter 09-4: Dividend Increases and Other Capital Distributions for the 19 Supervisory Capital Assessment Program Bank Holding Companies (PDF)

EU Agrees to Disagree on Banks Stress Tests

The International Monetary Fund’s (IMF) call earlier this week for Europe to conduct stress tests on individual banks has again put the solvency of European banks and the EU’s efforts to clean up bank balance sheets into the spotlight. The solvency ratios of European banks are often lower than those of their US counterparts, making them more vulnerable to write-downs and requirements to raise further capital. The IMF likened the stress tests to a good “spring cleaning.”

Most estimates show that European banks still have significant write downs ahead of them, which in turn will make further government interventions necessary. For instance, the Belgian government on Thursday had to step in to help its troubled banking sector by offering guarantees to KBC Bank. The measure became necessary through the possible default of MBIA Inc, the New York-based bond insurer.

However, European banks argue that US-style stress tests are less applicable to their institutions, because the economic fundamentals and accounting rules are different. The EU officials are also satisfied that individual national regulators have long been conducting stress testing and that there is no need to make them public.

German Finance Minister Peer Steinbruck on Wednesday criticized the idea of EU bank stress tests, saying, "We are seeing that the stress test in the US is worthless because the central bank exercised influence as well as the Treasury.” Meanwhile, France’s Banking Commission would not comment on the IMF proposal. Last month, however, the commission’s chairman, Christian Noyer, who is also governor of the French central bank, said he has every confidence in France’s regularly conducted stress tests.

The debate on the fundamental issue of who should supervise and perform stress tests seems likely to continue with widely diverging views represented. The Commission’s upcoming proposals for a new financial supervisory infrastructure in the EU are therefore much anticipated and will be closely scrutinized.

The early feedback on the stress tests in the United States is positive. The results of a Gallup Poll, released 13 May, show that Americans’ confidence in banks has improved “slightly, but to a statistically significant degree” since the Treasury posted the stress test data. In a Wall Street Journal survey of 52 leading economists, half rated the stress tests as helpful. Only time can tell if the stress tests will prove to be a significant factor in restoring US financial stability. Certainly the Obama Administration believes what Treasury Secretary Geithner has said, that “the bank stress tests should advance the process of repairing our financial system and provide a better foundation for recovery.”

Who Passed the Stress Test?

At 5 p.m. Eastern Daylight Time today, the Federal Reserve and Treasury unveiled the official results of the Supervisory Capital Assessment Program (SCAP), revealing that ten of the 19 participating banks need to increase their capital buffers for a combined total of $74.6 billion. The SCAP conducted stress tests on the nation’s largest bank holding companies to predict “potential losses, the resources available to absorb losses, and the resulting capital buffer needed” based on various economic scenarios.

The banks needing to increase their capital buffers will have to work with their primary regulators, in consultation with the FDIC, to develop a capital plan sometime in the next 30 days (by June 8, 2009), and they will have six months to implement the plans (by November 9, 2009).

Each capital plan must contain the following three elements:

  • A detailed description of specific actions the bank will take to increase capital in order to satisfy the capital buffer requirement. Treasury and the Fed encourage banks to raise new capital from private sources.
  • A list of steps to address weaknesses in the bank’s internal processes for assessing capital needs and engaging in capital planning.
  • An outline of steps the bank will take over time to repay government-provided capital.

As part of their 30 day review process, banks are also directed to evaluate their existing management and board of directors to make certain their leadership has the capability to “manage the risks presented by the current economic environment and maintain balance sheet capacity sufficient to continue prudent lending to meet the credit needs of the economy.”

The banks needing to increase their capital buffer (amounts in billions) are Bank of America ($33.9); Citi ($5.5); FifthThird ($1.1); GMAC ($11.5); KeyCorp ($1.8); Morgan Stanley ($1.8); PNC ($0.6); Regions ($2.5); SunTrust ($2.2); and Wells Fargo ($13.7). See the Fed report for more details.

Federal Reserve: Supervisory Capital Assessment Program - Overview of Results (PDF)

Stressed Out?

The Treasury Department is working to complete stress tests on 19 top U.S. banks. Reports are circulating that all the banks will receive a passing grade, but there is going to be some differentiation in the results between those that are particularly strong and those that are not. Several media outlets today are citing "senior Administration officials" as saying Treasury plans to release—or to encourage the banks to release—the results of the stress tests. The purpose for this, according to these officials, is to prevent rumors about "weak" institutions from causing investors, creditors, borrowers, and depositors to lose confidence in certain institutions. The release of the results will not occur before the end of the "earnings season"— April 24.

It does appear to us that the stress test results will be a contributing factor to a sorting of the banking industry into the healthy and the less healthy—to look at it in the most charitable light. Some banks are contributing to that sorting process by touting early their first quarter results and by openly discussing paying back the TARP funding they have received.

So faced with this developing story, we here at Financial Reform Watch have some questions we are pondering:

  • Will Treasury actually sort the banks into categories of strength?
  • What information will Treasury release and what information will the banks release?
  • Will the markets react as Treasury hopes to the release of information, or will they focus only on the less good results as a reason to drive down the values of certain institutions' stocks?

If this sorting process develops through the spring and the summer, talk of consolidation in the industry is likely to increase. So that supposition leads to questions as to whether or not Secretary Geithner will become an advocate for consolidation as Secretary Paulson before him did in suggesting through the capital injection process that certain banks—usually smaller ones—should be taken over by others.

In any case, the release of stress test results and information compiled in conducting the test could just as easily roil the markets as calm them in our view.