As President Donald Trump's administration works to roll back industry regulations deemed onerous, investors in banks like JPMorgan Chase & Co. (JPM - Get Report) , Bank of America Corp. (BAC - Get Report) and Citigroup Inc. (C - Get Report) could see another staple of oversight stripped away: annual "stress tests" by the Federal Reserve designed to ensure the firms are prepared for a big financial crisis.
Ken Leon, a four-decade veteran of the financial industry who now analyzes investment banks for stock-analysis firm CFRA Research in New York, predicts that regulators might make a surprise decision in 2018 to dump the tests, formally known as the Comprehensive Capital Analysis and Review. Doing so would give banks more room to pay out billions of dollars to shareholders in the form of dividends and stock buybacks.
The so-called CCAR tests were set up in the aftermath of the 2008 financial crisis to make sure banks have sufficient capital to survive a new crisis. Capital is the cushion of extra assets banks are supposed to keep on their balance sheets to absorb losses and prevent the need for government-funded bailouts. During the financial crisis, the world's biggest banks collectively got more than $100 billion in bailout cash from the Treasury Department in 2008 and took over $1 trillion of secret emergency loans from the Federal Reserve to stay afloat.
Part of the impetus for doing away with the stress tests is that banks, under pressure from regulators, have significantly increased their capital levels since the financial crisis, according to Leon. He predicts that regulators will announce plans at some point in 2018 to "sunset" the tests in two years.
"The banks are really in a position now where they're exceeding the minimum stress-test criteria," Leon said in a phone interview with TheStreet. "We're so many years out from the financial crisis now, and there's other tests that the Fed is doing."
The Trump administration in 2017 made good on its pledge to roll back post-crisis rules on the financial industry, installing former bank executives and lawyers to oversee key supervisory agencies like the Office of the Comptroller of the Currency and the Securities and Exchange Commission. He's also asked for cuts to the agencies' budgets, even amid growing concerns that markets are overheating, asset-price volatility has become eerily low and that the financial system could be targeted by a big cybersecurity attack.
Federal Reserve Chair Jerome Powell said during a U.S. Senate confirmation hearing in November that large banks have enough capital to keep lending to households and businesses "throughout the economic cycle, even when times are tough," according to Leon.
Randal Quarles, a former banking-industry lawyer, was nominated and confirmed in October as the Fed's vice chair for supervision following the resignation of Daniel Tarullo, who had championed the stress tests during his time as a member of the central bank's board of governors.
In June, the Treasury Department issued a report urging an "off-ramp from all capital and liquidity requirements" for banks that elect to maintain sufficiently high levels of capital.
According to CFRA's Leon, the largest banks increased their key capital ratio on average to 12.5% as of the first quarter of 2017 from 5.5% eight years earlier. And many analysts are already anticipating higher shareholder payouts; the average estimate of the pace of dividend payments in the third quarter of 2018 is roughly 40% higher than the run rate in the third quarter of 2017, Leon said in the interview.
There are risks, of course - mainly that the banks, especially as the regulatory handcuffs loosen, might again start taking outsize risks even as they keep less capital on hand to survive the next crisis. Some proponents of stiffer banking regulation argue that capital levels should be much higher still.
"Real-world financial crises may also underestimate the magnitude of chaos, confusion and contagion that impact funding problems at the large banks," Leon wrote in a report last month.
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