Fed stress tests stretch State Street, Goldman, Morgan Stanley

State Street worst performer among complex firms on capital; Goldman and Morgan Stanley on SLR

Large US banks hurdled this year’s Federal Reserve stress tests with ease, though a handful of dealers came close to failing on key leverage ratio measures. 

All 35 firms that underwent the Fed’s severely adverse scenario, the toughest round of the annual Dodd-Frank stress tests, reported stressed capital and leverage ratios above regulatory minimums. 

However, some major dealers came close to crossing the Fed’s red lines. State Street’s Common Equity Tier 1 (CET1) ratio was projected to trough at 5.3%, and its Tier 1 leverage ratio at 4.2%, in the course of the nine-quarter simulated stress period. The bank’s actual end-2017 ratios were 11.9% and 7.3%, respectively. 

The minimum stressed CET1 and Tier 1 leverage ratio needed to pass is 4.5% and 4%, respectively. 

Goldman Sachs came closest to failing the tests on the supplementary leverage ratio (SLR) measure, reporting a projected minimum of 3.1%, down from its actual end-2017 SLR of 5.8%. Morgan Stanley’s SLR minimum was 3.3%, down from 6.5%. Banks need a stressed SLR of 3% or higher to pass. 

Morgan Stanley was also projected to undergo the biggest peak-to-trough fall in capital. The bank was estimated to suffer a 920 basis point drop in its CET1 ratio in the course of the simulation – from a starting point of 16.5% to a minimum of 7.3%. The bank was also projected to see its Tier 1 leverage ratio plummet the most, by 400bp, from 8.3% to 4.3%.

Credit Suisse Holdings (USA) boasted the highest minimum stressed CET1 ratio, at 17.6%, from a starting ratio of 24.7%. By the Tier 1 leverage ratio measure, Santander Holdings USA was the strongest performer, reporting a projected minimum of 13%.

Northern Trust was projected to be the most resilient firm to this year’s severely adverse scenario, suffering a capital burn of just 90bp, from 12.6% to 11.7%.

Credit Suisse and Northern Trust topped the table on the SLR measure, with stressed minimums of 6.6% each. 

What is it?

The Dodd-Frank stress tests, now in their sixth year, subject the largest US banks to a series of economic shocks to test their resilience to a future financial crisis. The Federal Reserve devises a fresh set of adverse and severely adverse supervisory scenarios each year to test dealers against a range of potential disasters. The scenarios are nine quarters in length, with banks having to maintain capital and leverage ratio minimums throughout the stressed period in order to pass. 

This year’s severely adverse scenario simulated a deep global recession, together with an aversion to long-term, fixed-income assets. Yield curves were steepened in the US and a number of other countries under the scenario, while long-term rates remained elevated. US gross domestic product was projected to drop to 7.5% below its pre-recession peak and the unemployment rate increase to 10% by the third quarter of 2019. In addition, equity prices are projected to collapse by 65% and the US volatility index to spike above 60%, among other asset price gyrations. 

The results of the second round of stress tests, the Comprehensive Capital Analysis and Review (CCAR), are due to be published on June 28. These concern large bank holding companies, and factor in their own capital planning processes. A bank's CCAR performance dictates whether the Fed will greenlight their planned future capital distributions, making this a closely-watched stress test. 

Why it matters

The Federal Reserve insisted that this year’s severely adverse scenario would stretch banks even more than last year’s, in a show that it did not intend to grow complacent even in the midst of a strengthening US economy. That all dealers – the 18 advanced approaches firms and 17 other firms – passed regardless will gladden investors and soothe prudential regulators.  

However, it’s likely that analysts will keep a close eye on State Street, Goldman Sachs and Morgan Stanley when next week’s CCAR results come out. As these tests determine bank’s future capital distributions, a low pass mark – or a fail – could set back hoped-for dividend payments and share buybacks.

Get in touch

What leapt out at you from this year’s results? We’ll be poring over the Fed’s findings in more detail in coming days, and would welcome your feedback. Email louie.woodall@infopro-digital or tweet @LouieWoodall or @RiskQuantum.

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