Two banks fail stress tests

The U.S. arms of Spanish bank Santander and Frankfurt-headquartered Deutsche Bank failed the stress tests, the Federal Reserve announced Wednesday afternoon. As a result, regulators will not allow them to pay out dividends or other capital distributions to shareholders.

All U.S. banks passed the highly anticipated regulatory tests, although Bank of America did so only on a provisional basis.

Citigroup, which failed the test last year, made it through unscathed. That result will come as a relief to CEO Michael Corbat, whose job was thought to be at stake in the results.

Goldman Sachs, JPMorgan Chase, and Morgan Stanley all passed, but only after taking a “mulligan” to adjust their plans after initial problems flagged by the Fed.

Wednesday’s results reflect the second half of the stress tests, now in their fifth year, in which regulators look at each U.S. bank and its plans on an individual and qualitative basis to determine its safety.

Each bank must demonstrate that it has the financial health to survive a scenario devised by the Fed, in which unemployment skyrockets, the stock market collapses by 25 percent, housing prices crater, and corporations default on their debt in large numbers.

Last week, the first half of the stress tests showed that none of the 31 banks surveyed was expected to go below the minimum capital ratios required by the Fed in a quantitative assessment.

Based on Wednesday’s qualitative tests, 28 banks would withstand the simulated crisis, the Fed reckons, including companies such as Goldman Sachs that had to tinker with their plans to meet the grade.

“Our capital plan review helps ensure that the capital distribution plans of large banks will not compromise their ability to continue lending to businesses and households even during a period of serious financial stress,” Federal Reserve Governor Daniel Tarullo said. “It also provides a structured assessment of their risk management capacities.”

Combined with the review of how banks’ balance sheets would hold up in a financial storm, Wednesday’s exercise is meant to demonstrate the health of the U.S. financial system and increase investors’ confidence that bank failures are not likely.

In aggregate, the Fed believes that banks are far safer now than they were in the wake of the 2008 financial crisis.

By one measure, the ratio of capital to assets at large U.S. banks has more than doubled since 2009, from 5.5 percent to 12.5 percent at the end of 2014, an increase of $641 billion. Higher capital means that banks are less reliant on borrowing and are better able to withstand losses without having to miss a payment to creditors.

However, problems cropped up at individual banks in the Fed’s analysis.

Bank of America was given until Sept. 30 to address some problems relating to its modeling of revenues and losses and internal controls. If it doesn’t fix the problems by then, the Fed could halt its capital plans.

The Fed faulted Santander for “widespread and critical deficiencies” in its balance sheet management, including governance, internal controls and risk management. Santander’s U.S. branch is less than 10 percent of its global business. It is the second year in a row Santander failed.

The small portion of Deutsche Bank’s U.S. operations that was tested, the Fed said, has “numerous and significant deficiencies” in risk management, loss projections and internal controls.

Just because a bank did not fail, a senior Federal Reserve official said, did not mean that it received an “A” on its safety. The banks will be receiving feedback from the Fed on problems regulators might have found during the process.

Goldman Sachs, JPMorgan and Morgan Stanley had to resubmit their capital plans after the first part of the stress tests last week to avoid falling below minimum capital ratios during the nine quarters surveyed in this week’s examination. That resubmission has been described as a “mulligan.”

Without the mulligan, each bank would have fallen below one or more measures of capital ratios computed by the Fed. This year’s version of the stress test included an increase in corporate bankruptcies that may have disproportionately affected banks with high trading revenues, a senior Federal Reserve said.

The mulligans only involved the banks planning on paying out fewer dividends or engaging in fewer share repurchases. They cannot plan to raise more equity to pass the test.

Goldman Sachs announced following the release of the stress tests that it would increase quarterly dividends. Chairman and CEO Lloyd Blankfein said in a statement that the banks remains “focused on managing our resources dynamically, growing our client franchise, and generating superior returns for our shareholders while remaining well capitalized.”

The banks were informed of the stress test results Wednesday morning. They will be receiving letters from Fed supervisors on problems they might have found that need to be addressed within the next month.

The Fed official noted that the capital distributions planned by banks over the next nine quarters will amount to less than 60 percent of net income, meaning that they will continue to build capital of 40 percent of income over that time.

Citigroup, the big bank under the most scrutiny heading into Wednesday’s tests, announced a $7.8 million stock buyback. Corbat said that the bank has “worked very hard over the last twelve months to further strengthen our capital planning process…. We want Citi to be an indisputably safe and sound institution and will do everything in our power to make that the case, year in and year out.”