Learning from the Past

Edited by Vani Rao

Banks post better results; but doubts persist on financial stability

Citi Bank LogoThe Federal Reserve’s annual stress tests turned out to be more unpredictable, and less favorable for banks, than expected. This year, five banks including Citigroup Inc. (NYSE:C), HSBC North America Holdings, RBS Citizens Financial Group, Santander Holdings USA, and Zions Bancorporation  (NASDAQ:ZION) failed to pass the Comprehensive Capital Analysis and Review (CCAR), which is the Fed’s capital requirements under its big annual stress test.

These stress tests were created after the 2008 financial crisis, when banks were found to be overleveraged and overexposed to a bubbling real estate market. The annual stress test is one of the Fed’s most important tools to gauge the resiliency of major banks and ensure that they have strong capital positions.

However, the results show that lenders may still face obstacles to boosting dividends and buybacks, even as regulators say that these banks have doubled their capital since the first public stress test in 2009. The Fed is increasing scrutiny of the financial sector’s controls and planning processes as concerns about capital levels wane.

Tests that Matter

The CCAR results follow last week’s Dodd-Frank Act Stress Test (DFAST) results, in which 29 of 30 banks had enough capital on hand to endure a major economic downturn. However, the difference between DFAST and CCAR mainly revolves around capital action plans, which is what banks do with the capital earmarked for shareholders, i.e. offer dividends or buyback stock.

DFAST tests whether banks have sufficient capital to absorb losses and support operations during adverse economic conditions (think housing crash, unemployment increase, severe GDP drop, or stock market crashes) while using  a standardized set of capital action assumptions (The assumptions keep each bank’s current dividend and do not include share repurchase plans.)

Like the DFAST, CCAR tests banks under adverse economic scenarios. As part of the test, banks submit their capital plans and the Fed assesses whether or not the bank would be able to meet required capital ratios under the proposed action plan under shaky economic conditions. Simply put, can the bank afford to give those dividends to shareholders if the economy starts to falter? If the answer is yes, banks then announce their capital plans to the public. The CCAR tests are watched by investors more closely because they determine what banks will do with their dividend and buyback plans over the next four quarters.

Citi Facing the Heat

The Fed’s decision is a disappointment to Citigroup, which pledged to increase its dividend above a notional 1 cent a share for the first time since its near collapse during the financial crisis. The Board of Governors denied Citigroup’s plans to repurchase $6.4 billion worth of common stock through the first quarter of 2015 and raise its dividend by 500%, from $0.01 to $0.05 per share. The dividend trend for major banks since the financial crisis is shown below.

JPM Equity
Source Bloomberg

The Fed’s rejection of Citigroup is of particular interest not only because its peers like JP Morgan (NYSE:JPM) and Bank of America (NYSE:BAC) had their plans accepted, but also because Citigroup’s capital cushion a key measure of its strength comfortably exceeding the regulatory minimum.

The Fed’s criticisms echoed concerns voiced by investors and analysts after the discovery of a $400-million fraud in Citigroup’s Mexican unit last month. The fraud, involving a Mexican company, forced Citigroup to restate its earnings and raised questions about whether the bank is properly overseeing its units. One may recall that the Fed’s rejection of Citigroup’s capital plan in 2012 helped precipitate a leadership coup at the bank. Citigroup’s failure to pass the test that year heaped pressure on the board to oust Vikram Pandit from the Chief Executive role.

At first, it seemed as though the leadership change was ushering in a new era for Citigroup, which was rescued by taxpayers during the financial crisis. With Mr. Corbat at the helm, the bank passed the stress test in 2013 and its stock price soared. The Fed said that while Citigroup had made progress in the areas of “risk-management and control practices,” its capital planning process “reflected a number of deficiencies.”

In addition, the Fed stated that Citigroup had failed to make “sufficient improvement” in certain areas that supervisors had previously identified as “requiring attention.” Over the past three years, Citi has been systematically cutting risky assets at its Citi Holdings unit and bolstering its capital position. When the first part of the test was released last week, Citi was comfortably above the 5% Tier 1 common ratio at 7.2%, which made capital returns appear to be a near certainty. Even with its checkered history, this failure was unexpected. The Fed’s rejection is unequivocally bad news as Citi will be unable to provide good returns, thereby hurting its credibility.

Interestingly, Citi did not fail based on quantitative results. In fact, Citi’s performance on the test was quite strong. For capital plans to be eligible for approval, a bank must maintain a 5% Tier 1 common ratio under the stress scenario and after returning the amount of capital requested. With this plan, Citi still would have a 6.5% ratio under the stress situation, giving it significant breathing room. This ratio was higher than many of the banks that were approved. For instance, Wells Fargo’s (NYSE:WFC) Tier 1 common ratio was 6.1% and JPMorgan Chase’s was 5.5% during the period under review.

While Citi passed on the quantitative measure, it failed for qualitative reasons. In essence, the Fed does not think Citi has enough oversight and control over its business units. In other words, the Fed believes that Citi has to gain a better understanding of the risks of its various global units and projection capabilities during periods of duress. While Citi is clearly better than it was in 2008, the Fed believes more progress can be made.

citi last picCitigroup was the biggest recipient of the Federal bailout money during the crisis, getting $45 billion in cash infusions and many billions more in guarantees. Citi can resubmit a plan, but it will need to show better risk controls; hopefully, it can make specific improvements to satisfy the Fed. Given its sizable capital buffer, Citi most certainly has the capacity to return more to shareholders, and its request for $7 billion was not even that aggressive.

It is important to note here that the Fed allowed Bank of America and Goldman Sachs Group Inc. (NYSE:GS) to confidentially submit less aggressive capital plans last week when the first part of the test was announced. According to Bloomberg, the first request from Bank of America and Goldman Sachs would have resulted in quantitative failure. To avoid the embarrassment of failure, the Fed allowed both firms to submit more conservative plans and passed them on Wednesday, March 26, 2014. However, while GS and BAC were given an opportunity to alter their plans before submission, no such accommodation was made for Citi.

Changing the Goal Posts

In this year’s test, the Fed expanded the number of banks under review to 30 from 18, and included for the first time the American units of several large European banks. With many banks around the world focusing on raising capital levels, the Fed’s decision to allow a broader distribution from US groups is controversial. Some academics argue that dividends should not be increased until banks have reached the new tougher capital levels prescribed under the Basel III agreement of international regulators.

However, Fed officials believe that the tests are suitably stringent and that only healthy banks will be allowed to release capital to shareholders. The Fed has consistently raised the standards of its annual stress tests, leading some bankers to grumble that the regulators’ efforts to make the financial system safer may be choking off credit to the broader economy. Others have complained that the regulator each year is unfairly changing rules.

Not Everyone

The Fed pulled up Santander Holdings USA Inc., the US unit of Madrid-based Santander, for “widespread and significant deficiencies” across the firm’s processes. The central bank also pointed at HSBC North America Holdings Inc. and RBS Citizens Financial Group Inc. for estimates of revenue and losses in the test. The rejection means that lenders will not be able to increase dividends to their European parent companies, freezing them at the current levels. The Fed also rejected the capital plans of Zions Bancorporation, saying that its capital cushion fell under the regulatory minimum in the stress test.

Looking at the Brighter Side

Overall, the results of the annual test showed that most of the nation’s banking system had healed substantially since the 2008 financial crisis. Many of the 25 banks that passed the review lost little time to increase shareholders’ returns. For the first time since 2009, Bank of America announced a dividend increase to 5 cents a share. The bank also said that it was buying back $4 billion in stock. JPMorgan said it was increasing its quarterly dividend to 40 cents a share and buying back $6.5 billion of stock.

Challenges Remain

Economic downturns are unpredictable, so the test should be too. Not that bank investors liked it. Even the shares of banks that passed the Fed’s tests dropped on Thursday, March 27, 2014. In the past year, shares of financial firms have risen 26%, significantly more than the market as a whole. Much of that rise was based on the belief that banks would pass the Fed’s stress tests and would be able to higher dividends and share buyback.

Source WSA
Source WSA

However, billionaire investor Warren Buffett has said that he finds the obsession with dividends and buybacks odd. Investors can get their money back whenever they want; all they have to do is sell.

For banks, not quite six years after the financial crisis, the ability to return capital to shareholders, rather than needing to hang onto it to protect themselves in crisis, was supposed to be another key sign that the nation’s financial firms were safe haven again.

The stress test once again pointed out the hidden flaws of banks. The Fed approved just $55 billion in payouts out of the total proposed. A good chunk of the miss was Citigroup which expected to spend $8 billion in dividends and buyback; while two other banks, Bank of America and Goldman Sachs, only passed the Fed’s test after agreeing to cut back what they would pay to shareholders. Even JPMorgan ended up announcing that it would pay $1 billion lesser in dividends and share buybacks than expected.

The Fed also predicted that the banks’ legal troubles were far from over. As part of the stress tests, the Fed estimated that the nation’s largest banks could pay another $150 billion covering legal fees and buying back soured mortgages over the next two years.

Then there are interest rates, which are likely to rise in the next year. Higher interest rates could eventually be good news for banks; but many predict that it could cause trouble. Already, higher rates have significantly cut mortgage refinancing activity, which has been a big money maker for banks over the past two years. Loan growth in general has remained tepid. What’s more, the Volcker Rule, which restricts banks’ trading operations and other post-financial crisis regulations, will officially come into effect later in 2014.

At the same time, investors seem to be pricing a lot of growth into banks stocks. The shares of the nation’s six largest banks have an average price-to-earnings of 15. Those same banks have $6.7 trillion in assets on which they earned average returns of 1.2% last year, or around $80 billion. To earn $92 billion, or 15% more, banks would have to increase their returns to 1.4%, higher than it was before the financial crisis. The other option is that banks would have to increase their lending activities. Given the current headwinds, neither higher profitability nor more lending looks all that likely. In fact, experts will not have to construct a stressful scenario for banks to disappoint investors next year.

Bank stocks have been on a roll for a while; now they may face an uphill climb.

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