Banks Clear Capital Requirement Bar

The largest U.S. banks have significantly bolstered their defenses against a severe downturn since the financial crisis and could continue lending even during a deep recession, the Federal Reserve said it has concluded, signaling that many will win regulators' approval next week to boost dividends to investors.

In the first part of its annual stress tests released Thursday, the Fed calculated that 33 of the largest U.S. banks would have loan losses of $385 billion under a hypothetical scenario that envisions the U.S. unemployment rate more than doubling to 10%, the stock market losing half its value and financial markets becoming so topsy-turvy that short-term U.S. Treasury rates turn negative as investors pay the U.S. government to hold their money.

Still, the central bank said that despite such big losses, those institutions meet the Fed's definition of good health—even during a severe recession—due to a steady increase in capital on their books, an improvement in the quality of their loans, and a drop in costs related to crisis-era litigation.

Next week, the Fed will release the second part of the tests, which include regulators' decisions on whether to allow—or block—banks' plans to return capital to shareholders through dividends or share buybacks.

Thursday's results don't necessarily predict the Fed's verdict next week. In the past, banks have shown strong capital ratios in the first part of the tests, only to be deemed as failing in the second round, which uses a broader set of criteria. In the second round, the Fed judges banks not just by their balance sheets, but by how officials assess banks' risk-management practices.

The stress tests were created during the financial crisis and helped in 2009 to convince panicky investors that big banks weren't on the brink of collapse. Congress in the 2010 Dodd-Frank financial-overhaul law made annual stress tests mandatory, and the Fed has adopted its own rules tying shareholder dividends to the tests.

The goal is to force banks to manage their finances in a way that they would still be able to keep lending during the worst economic conditions, and to diminish the risk of big bank failures. The stress tests are just one of a number of new drills that regulators have been running with banks in an effort to prevent a new crisis. Banks also face new requirements to hold high levels of liquidity as well as capital, to try to prevent a short-term cash crunch. And they have to file annual "living wills" which show how—if all of those other defenses collapse and the banks find themselves on the brink of bankruptcy—they could be unwound without an infusion of taxpayer funds, or without traumatizing the broader financial system.

"The changes we make in each year's stress scenarios allow supervisors, investors, and the public to assess the resiliency of the banking firms in different adverse economic circumstances," Fed governor Daniel Tarullo said in a statement.

Critics say the Fed programs are overkill, going to extremes to prevent a crisis while hampering the economy's ability to recover from the last one.

"I think the Fed is trying to make these entities fail-proof; I think it's kind of spilling over the entire financial community," Rep. Randy Neugebauer (R., Texas) told Fed Chairwoman Janet Yellen during a congressional hearing Wednesday. "We've got economists trying to run banks," he added, blaming that for "anemic growth."

The stress tests "will make you very safe," Bank of America Corp. Chief Executive Brian Moynihan told a Wall Street Journal conference last week. "The question is whether it restricts lending."

The Fed said the 33 banks this year collectively maintained at least 8.4% high-quality capital as a share of assets, staying well above the Fed's 4.5% minimum even after being pounded by a severe economic downturn. That was also better than the 7.6% minimum in last year's test. The banks collectively started this round of tests with 12.3% capital at the end of 2015.

Thursday's results mark the second straight year in which all the banks taking the tests maintained capital levels above what the Fed views as a minimum allowance, a result that could help persuade the central bank to allow them to start distributing more capital to investors than they have in the past.

The Fed changes the details of its recession scenarios from year to year, so the specifics can hit one type of bank harder than another. Relative to last year, this year's negative-rate scenario took a tougher toll on traditional banking businesses that rely on deposits as a source of funding, a senior Fed official told reporters on a conference call. That was a contrast from last year, when large trading banks were harder hit than in the past because the Fed in that scenario assumed significant corporate defaults.

Since the 2008 crisis showed banks were relying too heavily on borrowed money, the Fed has been forcing banks to build capital, rather than return it to shareholders. But the regulator has slowly loosened the reins for banks that prove through the stress tests that they are adequately managing their risks.

Shareholders of banks that have had problems with the test, such as Bank of America Corp. and Citigroup Inc., have received paltry dividends compared to the owners of Wells Fargo & Co. and other firms that haven't had stress-test slip-ups.

In addition to running the stress tests on their current balance sheets, the banks have also submitted to the Fed their desired plans to return capital to investors, making the case that they could pass the test even after making those payouts.

If the firms determine, based on Thursday's results, that their capital plans would push them below the Fed's minimum required threshold, they have until Saturday to take a one-time shot at a "mulligan"—cutting their request for dividends or buybacks in order to stay above the Fed's minimum requirement.

The banks with ratios closest to the line this year included Huntington Bancshares Inc. and BMO Financial Corp. Each passed one of the ratios by less than half a percentage point.

Last year, Morgan Stanley, Goldman Sachs Group Inc., and J.P. Morgan Chase & Co. told the Fed they wanted to scale back their payout plans in the week between the first and second tests. All three firms would have been judged as failing the test without making an adjustment, but investors generally don't penalize firms for making an adjustment after the initial results, saying they prefer the firms to be aggressive in requesting to return capital.

Those three firms looked stronger this year. J.P. Morgan, for instance, had its Tier 1 leverage ratio fall only to 6.2%, compared with 4.6% after the first round of tests last year. Goldman Sachs's and Morgan Stanley's total risk-based capital ratio fell to a minimum of 12.6% and 13.5%, respectively, compared with 8.1% and 8.6% last year.

Germany's Deutsche Bank AG and Spain's Banco Santander SA, whose U.S.-based banks were the only firms to fail the tests last year, both appeared to breeze through Thursday's results with capital ratios far above the Fed minimums.

But last year, the two banks were tripped up because of what the Fed called risk-management problems, rather than insufficient capital levels. Both firms have been spending heavily on improving their stress-testing programs and will look for redemption when the Fed releases its round-two results next week.

Santander also failed the Fed's tests in 2014, meaning its U.S. unit risks the ignominious distinction of being the only firm to fail the test three years in a row.

Two other foreign-owned U.S. banks are taking the tests for the first time this year: BancWest Corp., a subsidiary of France's BNP Paribas SA, and TD Group US Holdings LLC, which is owned by Toronto-Dominion Bank.