Fed Unveils Expanded Stress Test

NEW YORK ( TheStreet) -- The Federal Reserve on Friday outlined the economic scenarios to be used in the 2014 stress tests of the nation's largest banks, while adding 12 more banks to the original group of 18 that have to submit annual capital plans to the regulator.

Investors have grown used to the regulator's annual stress tests and capital plan reviews of the largest 18 U.S. bank holding companies, especially for the "big six," which include JPMorgan Chase ( JPM), Bank of America ( BAC), Citigroup ( C), Wells Fargo ( WFC), Goldman Sachs ( GS) and Morgan Stanley ( MS).

Twelve other holding companies have been subject to the stress tests and capital plan reviews over the past four years, consisting mainly of regional players, including U.S. Bancorp ( USB) of Minneapolis, SunTrust ( STI) of Atlanta and BB&T ( BBT) of Winston-Salem, N.C., which had its initial 2013 capital plan rejected by the Fed in March.

While many smaller U.S. banks have their own annual stress tests, the "Gang of 18" has undergone a two-step process over the past four years. First, the companies undergo the Dodd-Frank Act Stress Tests, in which their third-quarter financials are tested using a "severely adverse" economic scenario developed by the Fed. Results of these tests are released in early March. The banks are gauged for their ability to remain well-capitalized, with minimum Tier 1 common equity ratios of 5% through the end of 2015, under a "severely adverse" economic scenario.

The second part of the annual stress test process is the Comprehensive Capital Analysis and Review (CCAR). The big banks must submit their annual plans to deploy excess capital through dividends, share buybacks and acquisitions by early January. These plans are then included in another round of stress tests, before the regulator decides whether or not to approve the capital deployment plans. The Fed announces second set of results a week after the first set of results is announced.

The Fed on Friday announced that the group of financial companies undergoing 2014 stress tests and requiring approval from the regulator for capital deployment would be expanded to add 12 more companies, adding regional names including Comerica of Dallas and Huntington Bancshares, as well as credit card lender Discover Financial, and the following five U.S. subsidiaries of foreign banks: BMO Financial, a unit of Bank of Montreal ( BMO); BBVA Compass Bancshares, held by Banco Bilbao Vizcaya Argentaria SA ( BBVA); HSBC North America Holdings, a unit of HSBC ( HBC); RBS Citizens Financial Group, a subsidiary of Royal Bank of Scotland ( RBS); and Santander Holdings USA, which is held by Banco Santander SA ( SAN).

RBS hopes to exit the group facing Federal Reserve stress tests before 2017. The company on Friday announced it would "accelerate the divestment" of RBS Citizens. "A partial initial public offering is now planned for 2014 and the Group intends to fully divest the business by the end of 2016," RBS said.

The stress tests, CCAR and other sets of regulator tests for smaller banks will all be based on the economic scenarios provided by the Federal Reserve on Friday.

The "severely adverse" scenario for the 2014 tests is typically brutal, as it assumes an increase in unemployment of four percentage points, with the U.S. unemployment rate peaking at 11.25% in mid-2015. The scenario also includes a decline in real U.S. GDP of nearly 4.75% through the end of 2014, a 50% decline in equity prices and a 25% decline in home prices.

"The international component of the severely adverse scenario features recessions in the euro area, the United Kingdom, and Japan, and below-trend growth in developing Asia," according to the Fed.

The 30 banks undergoing CCAR are required to submit their 2014 capital plans by Jan. 6.

The Federal Reserve said on Friday that the original group of 18 bank holding companies undergoing CCAR, "have increased their aggregate tier 1 common capital to $836 billion in the second quarter of 2013, the period of most recent data, from $392 billion in the first quarter of 2009. The tier 1 common ratio for these firms, which compares high-quality capital to risk-weighted assets, has more than doubled to a weighted average of 11.1 percent from 5.3 percent."

That's quite a load of additional capital being raised and built-up through earnings and asset dispositions.

JPMorgan Chase reported that as of Sept. 30, it had Basel I Tier 1 common equity of $145 billion, increasing from $135 billion a year earlier. The company's Basel I Tier 1 common equity ratio increased to 10.5% as of Sept. 30 from 10.4% a year earlier.

Bank of America reported $143 billion in Tier 1 common equity as of Sept. 30, increasing from $136 billion in September 2012. The company's Basel I Tier 1 common equity ratio declined to 11.1% as of Sept. 30 from 11.4% a year earlier.


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

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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.