Bank Stress Tests May Get More Stressful

NEW YORK ( TheStreet) -- The nation's biggest banks may be facing a much more difficult set of stress tests in 2014, according to KBW.

Several senior federal regulators have recently called for higher capital requirements for large U.S. banks. Senators Sherrod Brown (D., Ohio) and David Vitter (R., La.) in April introduced a bill calling for regulators to "would walk away from Basel III, and institute new capital rules that don't rely on risk weights and are simple, easy to understand, and easy to comply with."

Under the Basel III agreement, the focus is on the Tier 1 common equity ratio, which uses risk-weighted assets in the denominator, in order to incorporate the perceived risk of various asset classes. Cash has a zero risk-weighting, so it is not added to risk-weighted assets and it doesn't increase a bank's capital requirement. Direct obligations of the U.S. government have a 20% risk-weighting. Mortgage-backed securities with AAA or AA ratings have a 20% rating. A-rated MBS have a 50% risk-weighting, while BBB securities has a 100% risk-weighting and BB securities has a 200% risk-weighting under Basel III, because of the higher likelihood of default.

The Brown-Vitter bill would require regulators to focus on the "leverage ratio," which is a bank's Tier 1 capital divided by its average total assets. The leverage ratio is, of course, much easier to calculate than the Tier 1 common equity ratio, which can require some interpretation by the banks and regulators. Brown-Vitter would require a 15% leverage ratio, while Basel III requires a ratio of 3.0%. Current U.S. rules require banks to maintain leverage ratios of at least 5.0% to be considered well-capitalized.

When introducing their bill, Senators Brown and Vitter said if the bill passes, the largest U.S. banks "will be faced with a clear choice: either become smaller or raise enough equity to ensure they can weather the next crisis without a bailout."

Even though leverage ratios don't use risk-weighting, KBW analyst Frederick Cannon has written in several recent reports that the market -- as represented by beta (volatility) measures and credit default swap spreads -- places greater emphasis on leverage ratios than it does on Basel III ratios. The Basel III Tier 1 common ratio "is very complex, has to be computed internally by the company, and cannot be calculated externally by analysts," Cannon wrote in a note to clients on May 5, adding that "the second problem with Basel III is that the measurements do not appear to be accepted by the market as appropriate measures of risk. This is a major issue as it is exactly the same problem that pre-crisis regulatory ratios had."

In a note to clients on Sunday, Cannon wrote that the closer relationship in CDS spreads and beta measures to leverage ratios "supports regulators' moving towards a constraining leverage ratio for the largest banks."

Stress Tests

As required under the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act of 2010, the nation's largest banks each year are required to show that they could remain well-capitalized under a "severely adverse scenario," as determined by the Federal Reserve.

The Fed's annual stress tests for the nation's largest 18 banks follow a two-step process. First the Fed gauges the banks' ability to withstand a brutal recession while maintaining a minimum Tier 1 common equity ratio of 5.0%. A second round of tests factors in the banks' plans for returning capital to investors through dividend payments and share repurchases. Over the past two years, the tests have served as catalysts for bank stocks, as most of the major players have received regulatory approval for dividend increases and significant buybacks.

This year's stress tests completed in March were based on Sept. 30, 2012 financial reports and featured a nasty economic scenario, including a 4% increase in the unemployment during 2013, along with 5% negative GDP growth, a 50% decline in equity prices and a 20% decline in real estate prices.

Out of the 18 banks undergoing the Dodd-Frank stress tests, all "passed," according to the Federal Reserve's announcement on March 7, with projected minimum Tier 1 common equity ratios above 5% through 2014, except for Ally Financial, the former GMAC.

on March 14, the Fed said it had approved all 18 banks' capital plans except those submitted by Ally Financial and BB&T ( BBT), while granting conditional approval to the plans submitted by JPMorgan Chase ( JPM) and Goldman Sachs ( GSO). BB&T's plan was rejected based "qualitative" factors only. JPMorgan and Goldman had their plans for capital deployment approved, but were required to submit revised written plans by the end of the third quarter.

Cannon wrote on Sunday that "If regulators move to a higher Basel III Leverage ratio of 7% or 8%, that could be bad news for all of these big banks, except WFC, during the Federal Reserve's 2014 stress tests and capital planning process."

A change of focus by regulators to leverage ratios from risk-based Tier 1 common equity ratios would flip the picture for some of the nation's "big six" banks. Here's how they stack up by estimated Basel III Tier 1 common equity ratio at the end of March, according to KBWs data:
  • Morgan Stanley (MS): 9.80%
  • Bank of America (BAC): 9.42%
  • Citigroup (C): 9.30%
  • Goldman Sachs: 9.05%
  • JPMorgan Chase: 8.90%
  • Wells Fargo (WFC): 8.39%

Here are the big six again, ranked by estimated Basel III leverage ratio:
  • Wells Fargo: 7.37%
  • Goldman Sachs: 6.10%
  • Bank of America: 5.80%
  • JPMorgan Chase: 5.25%
  • Morgan Stanley: 5.15%
  • Citigroup: 5.14%

While few analysts expected the Brown-Vitter bill to pass, the recent trend is clearly to focus on stronger leverage ratio requirements for banks. Raising leverage ratio requirements to a range of 7% or 8%, could be seen as a "middle ground" by regulators to keep the Basel III agreement, which allows individual countries to raise the minimum leverage ratio requirement as long as the ratio is calculated under the Basel III rules.

And that could put quite a damper on the banks' capital plans next March.

-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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