What You Can Learn From How Small Banks Handle Financial Stress

UPDATE: This article, originally published at 8:43 a.m. on Thursday, June 11, 2015, has been updated with bank stock performance and Federal Reserve reporting requirements.

NEW YORK (TheStreet) -- When big banks like JPMorgan Chase  (JPM) and Wells Fargo  (WFC) undergo yearly stress tests by the Federal Reserve, the agency determines whether they pass or fail. Smaller banks -- those with less than $50 billion in total assets -- get to test themselves.

Starting Monday, however, they'll have to disclose the results. The new requirement, which will affect at least four dozen banks with $10 billion to $50 billion in assets, is one of the rules set by federal regulators implementing the Dodd-Frank finance reform law, which doesn't mandate a pass/fail rating for the smaller companies.

The banks, which together have assets totaling $1.08 trillion, must report the results between June 15 and June 30, according to a statement from the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency. The agencies won't comment publicly about the results or the disclosures, intended to help consumers and investors gauge the risk of a bank's operations.

The biggest of the banks affected is San Francisco-based First Republic (FRC), which held $48 billion in total assets at the end of last year, according to the Fed. The bank noted in its quarterly financial statements that it is already incurring costs to comply with heightened regulations and that those expenses will increase when its assets top $50 billion on an average annual basis, expected to happen at the end of the third quarter.

The bank has been ramping up its liquid assets in preparation, since $50 billion is the threshold for the government's designation of systemically important financial institutions, which face tighter regulatory requirements. First Republic added $600 million in high-quality liquid assets in the first quarter for a total of $3.7 billion, Chief Financial Officer said on the company's first-quarter earnings call in April.

Even if Congress approves proposals to raise the threshold to $500 billion, First Republic would continue to focus on liquidity, CEO James Herbert said. 

"There is always a right thing to do, whether it's the law or not," he said. "And the proper thing is to have a liquidity level as the bank grows."

Signature Bank, (SBNY) which is based in New York and had $27.3 billion in assets at the end of last year, is also spending more on regulatory compliance.

"It's clearly accelerated the last couple of years with the stress testing and the environment that we're in," Eric Howell, executive vice president for corporate and business development, said on the first-quarter earnings call on April 21. "We expect that we'll continue to spend at a pretty hefty pace for the next several years."

First Republic has gained 23% this year in New York trading, leading gains on the KBW Bank Index and outpacing larger companies like BB&T (BBT), with 5.6% and Citigroup (C) with 5.5%.

The latest federal regulatory tightening was timed to meet a deadline written into the original Dodd-Frank legislation. Several metrics are measured in the tests, including the company's Tier 1 capital ratio, which compares equity and reserves to outstanding loans; and planned dividend payments and stock buybacks. The banks will have to report what types of risks they measured. along with estimates of losses, revenue and net income and the biggest causes of changes in capital ratios measured by regulators, according to the Fed.

According to a January paper by Paul Glasserman and Gowtham Tangirala of Columbia Business School, the stress tests at larger banks "have become a central tool for enhancing the resilience of the banking system." Stress tests have become more predictable from one year to the next, the authors noted, and they give banks an incentive to avoid investments that would perform poorly in the tests and prompt regulators to insist on additional capital reserves.


Still, "whereas the results of stress tests may be predictable, the results of actual shocks to the financial system are not, and herein lies the concern," Glasserman and Tangirala noted. "The process of maturation that makes stress tests results more predictable may also make the tress tests less effective."

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