Bankers Have Less to Fear from 'Stress Tests'

By Ryan Tracy Features Dow Jones Newswires

Stress tests long dreaded by executives at the nation's largest banks are getting easier.

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The Federal Reserve on Wednesday will release the final results of this year's tests, which probe firms' ability to withstand a severe financial shock. Officials made the tests easier for some banks this year, and for the next time around they are preparing to further change the exams in fundamental ways.

The most significant shift would remove a major risk for banks: Failing the tests purely for subjective reasons. The so-called qualitative part of the tests has in past years created embarrassing failures for firms such as Citigroup Inc., Deutsche Bank AG, and Banco Santander SA.

Fed officials now envision a system where firms would generally only fail the test if their capital levels dipped below the level the Fed views as healthy -- in other words for quantitative reasons, not qualitative ones.

That likely means fewer test failures. Between 2014 and 2016, the Fed gave banks a failing grade nine times. Only once did a bank fail because of a low capital ratio: Zions Bancorp. in 2014.

The tests will continue to matter to investors. The Fed will still use them to audit banks' plans to boost dividends and buybacks for shareholders, and the numerical part of the exams will still be crucial to determining those payouts.

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Nevertheless, a reduced emphasis on the subjective aspects of the exams could make the tests far less tense for bankers.

"The qualitative [part of the tests] is a lot of process work," William Demchak, chief executive of PNC Financial Services Group Inc., said in a June interview.

He said the risk committee of the bank's board of directors discusses aspects of the exams at each regular meeting, even though sometimes "there is no reason to" do so because there haven't been significant changes to the firm's program. "But we do, to prove [to the Fed] we have a quality review."

PNC has never failed the tests.

The idea of a bank supervisor publicly calling out a bank's failings has always made some policy makers nervous. After all, one of supervisors' primary jobs is to prevent damaging "runs" that occur when the public loses confidence in banks and withdraws deposits en masse. If regulators have problems with bankers, they almost always address them privately.

Former Fed governor Daniel Tarullo, who helped build the tests while serving as the Fed's regulatory point man between 2009 and earlier this year, has said the Fed departed from a tradition of privacy in part because he and other officials were "stunned" during the financial crisis at what they viewed as banks' inability to quickly assess the risks they faced.

They created an annual stress test with two main parts. One judges whether banks' plans for paying out capital to shareholders would still allow them to withstand a hypothetical economic downturn. The other part is a "qualitative" evaluation of how they manage risks. If a bank fails either part, the Fed discloses they have failed the tests and reject their requests for higher payouts.

"The potential for embarrassing, public" stress-test failures "was intended to, and has, focused the minds of banks' senior management on their capital positions and capital planning processes," Mr. Tarullo said in an April speech.

In 2014, Mr. Tarullo and other senior Fed officials judged Citigroup hadn't made enough progress in improving risk management. The firm failed the qualitative portion of the tests, and spent about $180 million during the second half of that year to meet the Fed's expectations. The failure also meant Citigroup couldn't boost shareholder dividends.

Other firms spent tens or hundreds of millions of dollars on the tests to ensure that they didn't end up in Citigroup's spot.

In 2017 Fed officials changed the rules. For 21 of 34 big banks, the qualitative part of the tests would no longer be a basis for failure. The 21 firms -- those with less than $250 billion in total assets and less than $75 billion in assets in nonbank businesses -- could still face a reprimand from the Fed, but that would happen privately as part of the Fed's year-round, ongoing oversight.

In proposing the rule change, the Fed cited "the high public profile" of the tests and the risk that "noncomplex firms will overinvest in stress testing," even though they pose less risk to the financial system than larger, more complex peers.

The change means those 21 firms are breathing easier ahead of Wednesday's results.

Mr. Tarullo also said in April "the time may be coming" to remove the qualitative portion of the tests for all firms, even large, complex ones such as Citigroup, J.P. Morgan Chase & Co., Bank of America Corp., and Goldman Sachs Group Inc.

Fed governor Jerome Powell, serving in Mr. Tarullo's role until President Donald Trump nominates a Fed vice chairman in charge of bank rules, supported the same idea in Senate testimony Thursday.

"Many of our largest banking firms have made substantial progress toward meeting supervisory expectations," Mr. Powell said. "If that progress continues, I believe it will be appropriate to consider removing the qualitative [part of the tests] for those firms that achieve and sustain high-quality capital planning capabilities."

Write to Ryan Tracy at ryan.tracy@wsj.com

(END) Dow Jones Newswires

June 25, 2017 07:14 ET (11:14 GMT)