Bank of America: An Unanswered Question From This Year's Stress Test

By Markets Fool.com

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Make no mistake about it, Bank of America performed admirably on both rounds of this year's stress test, paving the way for the bank to boost its dividend by 50% and repurchase $5 billion worth of stock over the next 12 months.This is particularly good news today, given the turmoil and uncertainty ignited by the vote last week in the United Kingdom to separate from the European Union. The stress tests demonstrate that Bank of America has more than enough capital to survive whatever outcome may materialize, regardless of how severe it might be.

To pass this year's test, Bank of America and the other global systematically important banks, or GSIBs, didn't simply have to prove that they could make it through a financial crisis similar to 2008, they also had to convince the Federal Reserve that they could simultaneously absorb losses from an event akin to the 2011 European sovereign debt crisis. Oh, and on top of that, the stress test presupposed that a GSIB's largest counterparty went into default.

It's also worth noting that many of the assumptions underlying the test stack the odds against the participating banks. The Fed assumes, for instance, that a bank faced with such a scenario wouldn't cut its dividend, reduce operating expenses, or stop buying back stock until it exhausts its outstanding share repurchase authority. The nation's biggest banks have certainly been guilty of squandering capital in the past -- namely, by buying back tens of billions of dollars worth of stock at inflated valuations in the years leading up to the 2008 crisis -- but it's absurd to think they'd repeat this mistake while it's still fresh in their minds. Consequently, the fact that Bank of America not only passed this year's test, but did so with tens of billions of dollars' worth of excess capital, should put its shareholders at ease.

Going into the test, Bank of America was projected to have a common equity tier 1 capital ratio of 11.6%. Based on its risk-weighted assets at the end of last year, this means it had $163 billion worth of the highest-quality capital available to absorb loan and trading losses, as well as losses from a default of its largest counterparty.Bank of America then emerged from the Fed's hypothetical gauntlet with a common equity tier 1 capital ratio of 8.1% (this is before its planned capital actions are factored in). Using its projected risk-weighted assets at the end of the stress test's nine-quarter scenario, this means the North Carolina-based bank would have $123 billion worth of high-quality capital.

There's accordingly no question that Bank of America has built, over the past six years,what JPMorgan Chase CEO Jamie Dimon refers to as a fortress balance sheet. But -- and this is the point of this article -- even though we know Bank of America would have $123 billion worth of common equity tier 1 capital, there's less certainty around the question of how much the Fed would expect it to hold in order for to be considered well-capitalized for regulatory purposes -- which has implications for its ability to return capital in the real world.

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If you were to go off the instructions for this year's test, you'd be led to believe that Bank of America must meet a minimum common equity tier 1 capital ratio of 4.5%. That would equate to $69 billion worth of capital for the nation's second biggest bank by assets, which, in turn, means it emerged from the test with $54 billion in high-quality capital above its regulatory minimum.

The problem with this measure is that it applies to all 33 of the banks that were tested. And it does so despite the fact that, outside of the confines of the test, eight of the banks must hold more capital than the other 25. These are the GSIBs, which are subject to additional capital buffers that, while not fully phased in until 2019, equate to between 1% and 5.5% of extra capital relative to risk-weighted assets. Once its own buffer is factored into the analysis, this means Bank of America must actually hold a common equity tier 1 capital ratio of 5.875% to be considered well-capitalized, according to its latest 10-Q. This would reduce its excess capital post-stress test to $34 billion.

This may seem like an academic question, but it's the difference for Bank of America of having $54 billion in excess common equity tier 1 capital and $34 billion. And given that one of the bank's biggest challenges right now is its low return on equity, which is inversely related to the amount of capital on its balance sheet, this matters because it plays a role in the Fed's decision to approve or deny Bank of America's annual proposals to raise its dividend and/or share repurchase plans. To this end, it's fanciful to assume Bank of America would have passed the first round of this year's test with an ending common equity tier 1 capital ratio of 4.6% -- just above the purported minimum -- much less have been allowed to boost its dividend by 50% and increase its buyback authorization by $5 billion.

The net result is that even though the instructions to this year's test say the 4.5% common equity tier 1 capital ratio is the minimum Bank of America must hold to satisfy the quantitative component of the test, the reality is that its minimum ratio is actually 5.875%. Indeed, one of the Fed's governors all but said as much earlier this month, intimating that GSIBs would soon be held explicitly accountable for their buffers on the annual exam. Thus, while Bank of America did a great job on this year's test, it's important that we are all looking at the appropriate mark.

The article Bank of America: An Unanswered Question From This Year's Stress Test originally appeared on Fool.com.

John Maxfield owns shares of Bank of America. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.