Fed fails one bank in second round of stress tests

Two others met with conditional approval

During the second round of the 2018 annual stress tests, the Federal Reserve objected to one bank’s capital plan, but passed the other 34 largest banks.

Due to changes in capital caused by President Donald Trump’s tax reform law, two banks will be required to maintain their capital distributions at the levels they paid in recent years.

The board objected to the capital plan from DB USA Corp., a wholly owned subsidiary of Deutsche Bank, due to qualitative concerns. Those concerns include material weaknesses in the firm's data capabilities and controls supporting its capital planning process, as well as weaknesses in its approaches and assumptions used to forecast revenues and losses under stress.

The board also issued a conditional non-objection to the capital plans from Goldman Sachs and Morgan Stanley. Each firm's capital ratios, under the capital plans they originally submitted and with the one-time capital reduction from the tax law changes, fell below required levels when subjected to the hypothetical scenario. This one-time reduction does not reflect a firm's performance under stress and firms can expect higher post-tax earnings going forward.

The Comprehensive Capital Analysis and Review evaluates the capital planning processes and capital adequacy of the largest U.S. banks, including the firms’ planned capital actions, such as dividend payments and share buybacks. Strong capital levels act as a cushion to absorb losses and help ensure that banking organizations have the ability to lend to households and businesses even in times of stress.

When evaluating a firm's capital plan, the board considers both quantitative and qualitative factors. Quantitative factors include a firm's projected capital ratios under a hypothetical scenario of severe economic and financial market stress. Qualitative factors include the strength of the firm's capital planning process, which incorporates risk management, internal controls and governance practices that support the process.

Last year, for the second year in a row, all of the nation’s largest financial institutions passed their stress tests, meaning each company has enough capital on hand to survive a “severe recession.”

Then last week, the 35 largest banks in the U.S. passed the first round of the Fed’s annual stress test, but during the second round of stress tests, one bank could still fail the exam.

This was the expected outcome, as analysts have been anticipating a full pass on the first round. But experts warned this may not be the case with round two.

During the first part of the test, Goldman Sachs and Morgan Stanley barely passed. Concerns were also raised about Wells Fargo and Deutsche Bank, leading some to worry not all banks would pass the second round of testing.

And banks have, in fact, failed before. Prior to the past two years, when all banks passed the test, Bank of America failed the stress test three times, while Citigroup failed it twice.

And this year, despite one bank failing the test and two others receiving only conditional approval, the board was more positive on its outlook of the results.

“Even with one-time challenges posed by changes to the tax law, the CCAR results demonstrate that the largest banks have strong capital levels, and after making their approved capital distributions, would retain their ability to lend even in a severe recession,” Vice Chairman Randal Quarles said.

The Fed explained banks have increased their capital significantly since it first began testing in 2009. The common equity capital ratio of the largest banks increased from just 5.2% in 2009 to 12.3% in the fourth quarter of 2017. This is an increase of more than $800 billion in common equity to more than $1.2 trillion during the same period.

But regardless of this year’s results, the Fed is currently looking to eliminate the pass or fail score for bank stress tests. The new scoring system would simply give banks a capital ratio that the lender must meet during the following year based on the results of the test. These changes could take effect as soon as next year.

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