Banks that fail to show demonstrated progress
The results of the ’14 Dodd-Frank stress tests and capital review program will be released over the next two weeks. While this year’s program is largely consistent with ’13, new disclosures and new entrants into the program are the primary risks. Moreover, as the regulatory bar has been raised, the intensified oversight is expected to result in conservative distributions for all. Banks that fail to show demonstrated progress toward the myriad new/pending regulatory rules, exhibit outsized interest rate risk and/or operate with regulatory/compliance issues are most at risk in our view.
The annual rite of spring commences next week
On Thursday, March 20, the Federal Reserve will release the calculations of the Dodd-Frank Act Stress Testing rules. DFAST will not disclose the amount of approved capital distributions or capital plan approval/objections. The release largely focuses on individual bank post-stress capital ratios, PPNR, loan losses, and AOCI/OTTI. Conversely, the CCAR program (released Wednesday, March 26) emphasizes enterprise risk management/measurement, post-stress capital ratios, and approval/objections tied to both the capital plans and requested capital distributions. Importantly, this year’s stress test programs will release not only the results from the severely adverse stress scenario, but also each bank’s performance under the adverse scenario for the first time. The adverse scenario largely focuses on interest rate risk under different yield curve assumptions (particularly a steeper yield curve), which effectively ranks embedded interest rate risk for each of the banks.
Intensified regulatory scrutiny over the past year likely results in more conservative capital distributions. Overall, this year’s Comprehensive Capital Analysis and Review (CCAR) examination is essentially unchanged relative to the 2013 program. However, the intensified regulatory/compliance scrutiny exhibited over the past year is expected to result in more conservative capital distributions. To be sure, the industry has grown increasingly comfortable with the Fed’s expectations for both quantitative modeling and qualitative assessments. However, the Fed continues seemingly to raise the bar each year. The Fed is expected to evaluate each bank’s progress toward meeting the various Fed policies and Dodd-Frank rules (pending and final) as they relate to enterprise risk management, capital (standard, advanced, transition and final rules), liquidity, compliance/controls, and other quantitative/qualitative factors (Refer to Figure 6). Consequently, the banks have taken a more cautious posture toward capital plan approvals (primarily qualitative assessments vs. requested capital distributions) compared to the last couple of years. For example, select bank holding companies returned 44% of earnings in ’13 compared to current estimates of approximately 63% in ’14–a return we consider likely too high. Our sense is that total capital distribution will more likely fall between ~40% and 50% of earnings on average this year, particularly for the regionals. (Refer to Figure 1). While investors’ expectations are seemingly in sync with the large multinational banks, expectations appear too high for the large regionals in our view given the regulatory scrutiny. (Refer to Figure 2). While we are not expecting any absolute capital plan failures among the original 18, the potential risks are centered around the qualitative assessments and partial plan approvals. As a result, we believe aggregate capital distributions will likely become more conservative compared to years past on a relative basis.
Can the first-time participants climb the learning curve?
An additional 12 regional and foreign banks ($50B+ in total assets) will be participating in this year’s CCAR (previously participants in the Capital Plan Review – CapPR) in addition to the 18 original companies. Undoubtedly, the learning curve for CCAR has been steep over the last three years, and the additional 12 banks undertaking the process for the first time are most at risk to disappoint on any number of variables: risk management, capital planning, modeling, testing, measuring, data integrity, qualitative assessments, etc. Our sense is the banks most at risk are the new foreign bank entrants (not rated), including Bank of Montreal (NYSE:BMO), BBVA Compass, HSBC Holdings plc (NYSE:HSBC), RBS Citizens, Banco Santander, S.A. (NYSE:SAN), and UnionBanCal. Capital adequacy is not a factor in our view, but rather how high has the bar been set for these new banks relative to the original 18 banks–that’s the risk in our view.
Capital plans must reflect the revised capital framework under Basel III
As expected, the Federal Reserve indicated that stress scenarios and pro-forma capital levels would be run under the Fed’s revised Basel-III capital framework, including any estimated SIFI capital surcharge and the company’s Tier 1 Common ratio. Additionally, the Fed has introduced an additional threshold for certain U.S. banks with substantial trading or custodial operations, with the incorporation of a counter-party default scenario, global shock, and counter-party risk evaluation. The individual banks are required to disclose their internal stress test results under the severely adverse scenario no later than March 31– an indication of the compatibility/ transparency of internal stress test models compared to the Fed’s internal stress models for each company.
As in the past, the capital planning and stress testing program, including the associated complexity and transparency, continues to evolve. The fourth year of the CCAR program (although the foundations date back to the 2009 Supervisory Capital Assessment Program) demonstrates the evolving transparency of the Federal Reserve’s process and additional qualitative/quantitative risk assessments. As an example, the 2011 examination essentially concluded with a brief press release from the Federal Reserve. However, the last two years have included additional transparency as well as quantitative and qualitative disclosures. The 2013 CCAR program included a detailed release of the Federal Reserve’s myriad economic assumptions, in addition to the staggered release dates of the bank’s internal forecasts and approved capital actions. For 2014, the program has incorporated a counter-party default scenario, global market shock, and counter-party risk transfers that result in significantly lower RWAs (i.e., SPVs and sponsored affiliates) and various interest rate curve assumptions.
The 2014 CCAR encompasses 16 domestic measures of the underlying U.S. economy (in addition to 12 foreign indicators), including a severely adverse stress scenario encompassing GDP contraction of -3.70% in 2014, average unemployment of 10.2%, average change in the Dow market index of 8,943 (down as much as 40-50% from current levels), and a 36 point decline in the HPI between Q413 and 1Q16 (trough projection). Overall, we would note that the Federal Reserve has softened its assumptions under the severely adverse scenario, including lower peak unemployment levels, and modestly better trough economic contraction (see Figure 1 for details). In addition, The adverse scenario largely focuses on interest rate risk under different yield curve assumptions (particularly a steeper yield curve), which effectively ranks embedded interest rate risk for each of the banks.
Required details of the capital plan are comprehensive and center on several investor focal points
Similar to last year, elements of the capital plan focus on pre-provision net revenue (PPNR), global shocks, funding/liquidity, AOCI/OTTI and various supervisory risk factors. In addition, this year’s assessment includes additional interest rate scenarios (5-year Treasury yield and Prime) as a means to more effectively incorporate the shape of the yield curve