The Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank act stress test (DFAST) that goes with it assess banks on two different metric, excess capital and excess leverage. While a poor result on either metric can prevent a bank from going forward on its capital return plans, the two are far from equivalent and banks that were limited by leverage have a few more options than those that were limited by capital.
“The banks that have the Tier 1 leverage ratio as their limiting factor, such as JPM, BAC and AXP, can grow the amount of common equity they can return in the upcoming CCAR test simply by issuing more preferred stock over the course of the year,” writes Bernstein Research senior analyst John E. McDonald in a June 11 report.
Preferred share offerings could balance out leverage/common capital ratios
McDonald explains that JPMorgan Chase & Co. (NYSE:JPM) had $10 billion less excess capital when measured against its Tier 1 leverage ratio minimum than when you measure against its Tier 1 common capital ratio minimum, Bank of America Corp (NYSE:BAC) had $2 billion less, and American Express Company (NYSE:AXP) had $300 million less. By issuing preferred stock before next year’s stress test, these banks (and any others who think they might be in that situation come 2015) can even the two metrics out a bit and open the door to higher capital returns.
While he doesn’t have any specific suggestions for banks that performed better relative to Tier 1 common than Tier 1 leverage, McDonald also points out that Citigroup Inc. (NYSE:C) had $8 billion less excess capital relative to Tier 1 common as opposed to Tier 1 leverage, Wells Fargo & Co (NYSE:WFC) had $7 billion less, U.S. Bancorp (NYSE:USB) $5 billion less, and PNC Financial Services Group Inc (NYSE:PNC) $4 billion less.
CCAR: Planning difficult as stress test continues to evolve
One significant risk to this plan is that the CCAR is still evolving, and banks don’t know the exact details of next year’s test. This year the big change was that the Federal Reserve did its own balance sheet projections instead of relying on the banks’ own numbers, and it used harsher assumptions than they did.
“The y/y inconsistency in the Fed’s CCAR results runs the risk of deterring banks from more aggressively expanding their annual capital return requests and investors from fully valuing future excess capital in today’s stock prices,” writes McDonald.
The Fed has said that it wants to see banks continue to build capital, so this reluctance might be as more of a feature than a bug from their perspective. But until the stress test becomes more predictable, banks are less likely to use strategies like the one that McDonald suggests to maximize capital return.