Bank Stress Tests Are Cruel, but Fair: Street Whispers

Philip van Doorn - The Street  NOV 16, 2012 3:23 PM

The Federal Reserve's next round of bank stress tests will use a particularly "severely adverse scenario," but will also allow banks to reduced planned dividend increases or share buybacks.


For its next round of stress tests for the 19 largest US bank holding companies, the Federal Reserve has introduced some new twists, but has also thrown a gift to the banks that may face rejection of their initial plans to return capital to investors.

Companies that had their initial 2012 capital plans in March rejected in full or in part, including Citigroup (NYSE:C), SunTrust (NYSE:STI), and Fifth Third Bancorp (NASDAQ:FITB), had to wait until August for their revised capital plans to be approved. Of the three, only Fifth Third was approved in August for a dividend boost. Neither Citi nor SunTrust requested a dividend increase or share buybacks in their revised 2012 capital plans.

During the next round of stress tests, banks with capital plans rejected by the Federal Reserve will receive feedback during the stress test process and can lower their capital return plans before the Fed approves or rejects the capital plans, increasing the chances of modest -- or better -- returns of capital to investors.

According to Credit Suisse analyst Craig Seigenthaler, this "one-time adjustment" option will enable banks whose initial 2012 capital returns were rejected, as well as banks like Regions Financial (NYSE:RF) and Zions Bancorporation (NYSE:ZB-PC) -- both of which, in 2012, repaid government bailout funds received in 2008 through the Troubled Assets Relief Program or TARP -- to present more aggressive plans to return capital during 2013 than previously expected.

For the 2012 stress tests conducted during the first quarter, the Federal Reserve used an "Adverse Scenario" that included real US GDP contracting "sharply through late 2012, with the unemployment rate reaching a peak of just over 13% in mid-2013," while also assuming "that US equity prices [fell] by 50% from their Q3 2011 values through late 2012 and that US house prices fall by more than 20% through the end of 2013." In addition, "foreign real GDP growth [was] also assumed to contract, with growth slowdowns in Europe and Asia in 2012."

In order to have their capital plans approved, the banks subjected to the stress tests had to show that their estimated Tier 1 capital ratios at the end of 2013 would remain above 5%, "with all proposed capital actions through Q4 2013."

For the next round of stress tests, the Fed requires bank holding companies to show that they can maintain a "Tier 1 common ratio of 5% on a pro forma basis under expected and stressful conditions throughout the planning horizon," which includes a far less severe Adverse Scenario than the previous round of stress tests, but also includes a new "Severely Adverse Scenario."

Adverse Scenario

The 2013 adverse scenario "features a moderate recession in the United States that begins in the fourth quarter of 2012 and lasts until early 2014; during this period, the level of real GDP declines 2%, and the unemployment rate rises to 9.75%." The adverse scenario also includes CPI inflation rising to 4% and equity prices dropping by 25% through the middle of 2013, with home prices declining "more than 6% during 2013, and commercial real estate prices falling 4.5% during 2013." Also under the new Adverse Scenario, short-term rates rise from their current range of between zero and 0.25% in order to combat inflation, reaching 2.5% by the end of 2013, while "the yield on the long-term Treasury note increases by less but still rises above 3.5% by the end of next year; thus, the yield curve is both higher and flatter in 2013."

Adding further to the misery under the Adverse Scenario, mortgage rates rise, while "corporate borrowing rates also move significantly higher, to more than 7% by the end of 2013, despite only a modest increase in spreads."

Severely Adverse Scenario

The Fed's new severely adverse scenario is similar to the 2012 adverse scenario, but nastier in some ways. "In the United States, the severely adverse scenario features a severe recession, with the unemployment rate increasing 4 percentage points from current levels (an amount similar to that in severe contractions over the past half-century). Notably, the unemployment rate remains above any level experienced over the last 70 years from the middle of 2013 to the end of the scenario."

The Federal Reserve also said that under the severely adverse scenario, domestic real GDP declines by almost 5% between the third quarter of 2012 and the end of 2013, with inflation slowing to 1%. Equity prices fall by over 50%, while housing prices and commercial real estate prices plunge by more than 20% by the end of 2014.

Under the severely adverse scenario, "short-term interest rates remain near zero through 2015," while "the yield on the long-term Treasury note declines to 1.25% in 2013 before edging up about 1 percentage point by the end of 2015. Spreads on corporate bonds ramp-up to 550 basis points over the course of 2013. As a result, despite lower long-term Treasury yields, corporate borrowing rates rise and reach a peak of 6.75% in mid-2013."

Meanwhile, "the international component of the severely adverse scenario features recessions in the euro area, the United Kingdom, and Japan and below-trend growth in developing Asia," with the eurozone slipping "into recession in the fourth quarter of 2012 and remaining in this state until the end of 2013." According to various reports, the eurozone has already slipped into a recession.

The Fed said that "the main qualitative difference between this year's supervisory severely adverse scenario and last year's supervisory stress scenario is a much more substantial slowdown in developing Asia," including "a sharp slowdown" in China. "This feature of the scenario is designed to assess the effect on large US banks of the important downside risks to the global economic outlook that could result from a sizeable weakening of economic activity in China," the regulator said.