Five Things to Watch in Bank Stress Tests

It's final exam time again for the nation's largest banks. The two-part stress test of U.S. lenders is set to kick off Thursday with an industrywide checkup of who would best handle a hypothetical period of market turmoil.

Started after the financial crisis and administered by the Federal Reserve, the stress tests have evolved as banks boosted capital dramatically. But they still serve as a warning to regulators about banks that might face problems if economic conditions worsen significantly.

Here are five things to watch for this week as the Federal Reserve prepares to publish its findings.

1. Payout Ratios Expected to Rise Again

The biggest reason investors care about this month's stress tests: it determines how big their banks' dividend will be for the next 12 months. This is determined by the second part of the tests, which will be made public on June 28. After the financial crisis, many banks scaled back their dividend and couldn't boost it again until regulators were confident the bank held enough capital. The same restraint applied to share buybacks, another shareholder-friendly gesture that makes regulators nervous because it depletes a bank's capital. In recent years, the Fed has given banks permission to increase buybacks and dividends, in some cases beyond 100% of their net income.

2. Big Stakes for Two Big Banks

Citigroup Inc. and Bank of America Corp. are hoping for a stress-free test. New-York-based Citigroup and Charlotte-based Bank of America have the lowest price-to-book ratios of America's large banks. In part, that reflects concerns about their strategies and past missteps that led to big losses. The banks have been challenged to increase dividends and buybacks. Citigroup failed the Fed's stress tests in 2012 and 2014, while Bank of America was criticized in the 2015 test for internal-control weaknesses after disclosing a costly error on the 2014 test.

3. Focus on Real Estate

Each stress test drills down into different potential problems with the economy. This is disclosed ahead of time and factored into the both parts of the test. This year, the Fed is presenting lenders with scenarios that include 10% unemployment, a recession in Europe and a sharp drop in housing prices. It's also watching commercial real estate, which some believe has gotten extended and risky as the post-crisis economic expansion ages. The sector has faced added concerns due to the persistent problems retailers have faced dealing with online competitors such as Amazon.com Inc.

4. Some Banks Get a Pass

In one way, the test will be easier this year for a significant number of big banks. The Fed announced earlier this year that 21 firms with "less complex operations" will no longer be subject to the qualitative portion of the second part of the test, known as the Comprehensive Capital Analysis and Review, or "CCAR." This part of the test, which will still be applied to 13 of the largest banks, has been criticized over the years for being unpredictable and subjective. Regulators have said that the qualitative test was more important as banks got used to taking the stress test and for those giant institutions like J.P. Morgan Chase & Co. whose failure would cause systemic problems globally.

5. Does Wells Fargo End Well? It's been a rough stretch for the third largest U.S. bank by assets. In September, Wells Fargo settled civil charges with federal regulators over allegations employees created as many as 2.1 million phantom retail accounts. Then, its CEO left, regulators rebuked the bank over its "living will" contingency plan, and in March, the bank suffered a downgrade of its Community Reinvestment Act rating. The bank has been working to clean up its problems, but some investors fear there's one more rebuke to come with this year's stress test.

Write to Aaron Lucchetti at aaron.lucchetti@wsj.com

(END) Dow Jones Newswires

June 22, 2017 10:10 ET (14:10 GMT)