Federal Reserve's stress tests give U.S. bankers heartburn

  • Article by: THE ECONOMIST
  • Updated: March 30, 2014 - 11:00 AM

The current mood in America’s financial markets is enthusiasm for companies that can receive investment now with the prospect of using it to make more in the future. The exceptions are banks, for whom the ability to return capital now rather than later is seen as a critical indicator of health.

On Wednesday the Federal Reserve disclosed the results of its “comprehensive capital analysis and review” determining which of the country’s 30 largest banks could increase their dividends and share buybacks.

The precise criteria are deliberately kept murky to keep banks from gaming them, and the results produced some shocks. Most banks had their plans approved but Citigroup and the American operations of HSBC, RBS Citizens and Santander were all rejected while Goldman Sachs and Bank of America passed only by tweaking their submissions.

One other institution, Utah-based Zions Bancorporation, had its plan rejected as well but this had been expected because it had flunked an earlier stage of the test.

For Citi, the results were a disaster. Its shares fell 6 percent on the news. “We are deeply disappointed,” said Michael Corbat, its chief executive.

Sympathy may be scarce. Mike Mayo, a provocative analyst at brokerage firm CLSA, urged that someone be held accountable. It is Citi’s second failure — the previous one created the vacancy for Corbat’s current job.

Fed cites ‘deficiencies’ at Citi

In an 87-page release, the Fed spelled out its objections. In Citi’s case, these included “deficiencies” that had been identified previously, including insufficient ability to produce models on the impact on revenues and losses for “material parts of the firm’s global operations.”

HSBC, RBS Citizens and Santander, which were included in the test for the first time, were granted some leeway but were nonetheless still found to have inadequate ­governance and capacity to evaluate risk.

Zions, Goldman Sachs and Bank of America were all judged to have inadequate capital in the case of a severe crunch under their original plans but Goldman and Bank of America were dexterous and informed enough to make adjustments. Why others did not do the same raises questions about both their regulatory ties and the evaluation process.

HSBC issued a statement suggesting that it was surprised by the result, noting that it had done particularly well in the first evaluation based on its current capital position, and that it had been working closely with regulators. If its failure serves any purpose, it is to highlight that regulators seem to keep shifting the goalposts.

Part of the test is based on numbers drawn from a hypothetical crisis such as a 50 percent drop in the stock market and 25 percent drop in housing prices, along with a sharp increase in unemployment. But new facets of the test go beyond numbers to look at operations.

“It is clear [that] standards are being ratcheted up, and the most important part is qualitative — the assessment of the bank’s ability to evaluate its own risks,” said Til Schuermann, a partner at ­Oliver Wyman, a consulting firms.

In response to the Fed’s results, 28 of the banks released their own expectations of what would unfold in a crisis. An analysis by Oliver Wyman showed that banks and regulators agree that credit cards will suffer the most severe losses, and their estimates are similar.

There are, however, sharp divergences elsewhere, particularly concerning losses should property values tumble. Banks reckon the impact will only be one-third to one-half as severe as the Fed believes.

Copyright 2013 The Economist Newspaper Limited, London. All Rights Reserved. Reprinted with permission.

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