While Goldman Sachs, along with 32 other financial institutions in the U.S., recently sailed through the first phase of the Federal Reserve’s annual Comprehensive Capital Analysis and Review, the premier investment bank and its close rival Morgan Stanley saw their key capital ratio metric take a significant hit under the test scenario ((CCAR 2020 Results, Federal Reserve Website)). In fact, the minimum CET1 ratio for Goldman Sachs (6.9%) came close to the 5% cut-off under the severely adverse scenario – something that is likely to weigh on its capital return plans for this year. Despite a similar decline in its CET1 ratio under the test scenario, Morgan Stanley’s capital return plans shouldn’t be affected as the banking giant has the highest CET1 figure among all major U.S. banks.
We simplify the key points to put these tests in perspective below. We also summarize how the largest U.S. banks fared in the Fed’s 2020 stress test in an interactive dashboard – parts of which are captured below.
The fact that all banks cleared the stress test comes as no surprise, as no bank has had trouble with the quantitative phase of the tests since 2014 thanks to the massive buildup of equity capital across the industry to comply with stringent capital requirements. The tenth iteration of the Dodd-Frank Act Annual Stress Test involved 33 large financial institutions, which represents well over 80% of the total banking assets in the U.S. The Fed detailed the scenario to be tested in early February – which includes some modifications to economic conditions under “severely adverse” scenario and removal of “adverse” scenario from the supervisory stress test.
An Overview Of The Test Scenario
Since it was first conducted in 2009, the Federal Reserve’s annual Comprehensive Capital Analysis and Review for banks have been tracked closely by banks, lawmakers, investors, and the public at large. This is because the review process – and specifically the stress test conducted as a part of it – is an important tool in the Fed’s arsenal to ensure that the country’s financial system can withstand an extreme adverse economic scenario in the future. As these tests aim to gauge the strength of each of the country’s largest financial institutions under conditions similar to those seen during the economic downturn of 2008, they help the Fed advise individual firms about how much they need to shore up their balance sheets if necessary. This time around, the stress tests look much more relevant with the Covid-19 pandemic presenting an unprecedented challenge to the global economy.
The purpose of the stress test is to ensure that the banks have enough capital to lend to customers and businesses even under extremely trying economic conditions. The test scenario includes 28 variables that capture various aspects of the global economy. Of these, 16 variables are related to economic activity, asset prices, and interest rates in the U.S. economy. The remaining 12 variables comprise of 3 features: real GDP growth, inflation, and the U.S./foreign currency exchange rate, for 4 key countries. The underlying idea is that if the financial institutions can hold their ground under such extreme circumstances, they will be well-positioned to withstand an adverse, but more likely scenario in the future.
In addition to its normal stress test, the Federal Reserve Board conducted a sensitivity analysis to assess the strength of banks under three hypothetical scenarios due to the current coronavirus crisis: V-shaped recession and recovery; a slower U-shaped recession and recovery; and a W-shaped double-dip recession.
A Quick Look At The Performance Of Each Institution
The key takeaway from the Fed’s stress test is the impact on Common Equity Tier 1 (CET1) common ratios for each of the 33 institutions tested under the severely adverse scenario. Notably, the combined CET1 capital ratio for the 33 participating companies was 12.0% for Q4 2019, with the figure falling to a minimum of 9.9% under the severely adverse scenario.
While each of the banks saw some movement in this benchmark figure under the test conditions, the amount it actually changed for a particular bank is governed by the bank’s business model, loan portfolio as well as the type of assets on its balance sheet. The table below represents the change in CET1 ratios for the U.S.-based Global Systemically Important Financial Institutions (G-SIFIs) from their current figures to their minimum levels as determined by the test for a “severely adverse” situation.
It should be noted that the minimum CET1 capital ratio figure for an individual bank needs to remain above the 5% cut-off to pass the stress test. From the chart above, it is evident that the minimum CET1 ratio for Goldman Sachs (6.9%) came close to the 5% level under the severely adverse scenario. This is likely to weigh on its capital return plans for this year.
Some other key observations from the stress tests:
- Deutsche Bank and Credit Suisse are the best capitalized U.S. subsidiaries of foreign banking giants. In general, the foreign bank’s U.S subsidiary has an upper hand as these subsidiaries usually represent a small, low-risk part of these banks’ more diversified business models.
- However, 4 of the largest financial institutions based outside the U.S. – Deutsche Bank, HSBC, Credit Suisse, and BNP Paribas – observed a steep drop of more than five percentage points in their minimum CET1 common ratios.
- Among the U.S. banks, custody banks BNY Mellon and Northern Trust figure among the best-capitalized firms in the list, and are also the ones least affected by the test scenario.
- Trading-focused banking giant Goldman Sach witnessed the sharpest declines in minimum CET1 common ratios among U.S. banks, as the test scenario shaved off more than six percentage points from the benchmark.
- Further, BMO Financial, credit card giant Capital One, and Morgan Stanley closely followed Goldman Sachs with more than 5 percentage point drop in minimum CET1 common ratios.
What Do These Results Mean For These Banks In The Near Future?
The most immediate impact of the announced stress test results for the banks will be on their capital plans for the year. In light of the coronavirus crisis and economic slowdown, the Federal Reserve Board has decided to suspend all share repurchase in the third quarter for the year. Further, there would also be a cap on dividend payout, with this figure being limited to the amount paid in the second quarter as well as to an amount based on recent earnings.
Although most of the big banks are likely to announce lower share buybacks and dividends in the current year as compared to 2019, we expect JPMorgan and Bank of America to lead the pack this time as well.
You can compare changes in CET1 ratios for these banks under the severely adverse scenario in more detail on our interactive dashboard.
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