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Fed to Give Failing Stress Test Banks Second Chance

The Federal Reserve will give the 19 largest banks a preliminary result of its capital stress test, offering institutions that fail a chance to adjust their dividend and stock buyback policies.

The change comes after Citigroup Inc. and SunTrust Banks Inc. (STI) narrowly missed meeting the 5 percent tier one common equity to risk-weighted assets minimum capital ratio in the 2012 test at 4.9 percent and 4.8 percent respectively. Ally Financial Inc. (ALLY) had a stressed ratio of 2.5 percent in the last test.

While the change gives bank boards a second chance, the Fed will also publish the result of their initial capital proposal, showing how far the firms missed in their first attempt. A severe shortfall on the first attempt will generate greater scrutiny of a bank’s capital planning process by regulators, according to a bank supervisor who declined to be identified because the tests are not completed. Even banks that pass the minimum stress ratio could fail if the Fed detects their capital planning process is flawed, the Fed’s instructions said.

“The ability to appeal obviously not only reflects Citi and SunTrust, but a lot of requests from the industry for a second hearing,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington consulting firm specializing in bank regulation.

The Fed’s disclosure of a bank’s preliminary request “injects a lot of rigor into the process,” she said. “There is tremendous pressure on the banks now on getting it right the first time.”

Stress Test

The Fed established the annual stress tests in 2009 to restore confidence in the financial system after the worst financial crisis since the Great Depression brought down Bear Stearns Cos. and Lehman Brothers Holdings Inc. Regulators have since complemented the test with a capital planning requirement to improve boards’ management of risk and dividend and stock buyback decisions.

“The Federal Reserve has been focused -- and will remain focused -- on ensuring the nation’s largest financial institutions have enough capital to weather severe, unexpected conditions and still continue lending to households and businesses,” Fed governor Daniel Tarullo said today in a statement released by the central bank.

The Fed’s rejection of Citigroup’s plan was a blow for then-Chief Executive Officer Vikram Pandit, who had primed shareholders for more rewards. Pandit, who cut the bank’s dividend during the financial crisis, filed a new plan in June without a request for an increased dividend or share buybacks, ending his push for a 2012 payout. The episode was among a series of setbacks that led the bank’s directors to oust Pandit in October, a person familiar with the matter said at the time.

No Comment

Shannon Bell, a spokeswoman for the New York-based lender, declined to comment on the Fed’s action today.

The 19 largest banks have boosted their tier one common equity to $803 billion in the second quarter of 2012 from $420 billion in the first quarter of 2009, the Fed said in a press release.

“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 10.9 percent from 5.4 percent,” the Fed said.

The KBW Bank Index of 24 large U.S. banking companies has risen 23 percent this year compared with a 10 percent gain for the Standard and Poor’s 500 Index.

No Panacea

“Capital is not the panacea,” said Sabeth Siddique, a director at Deloitte & Touche LLP and a former assistant director at the Fed Board’s bank supervision unit. “It has to be balanced with good risk management and controls.”

The Fed said it plans to release the economic and financial market scenarios for the stress test at 4 p.m. in Washington Nov. 15. The test will apply to 30 banks, the 19 largest plus 11 more bank holding companies with assets of $50 billion or more.

Despite requests and complaints by banks, the Fed won’t share its models on how loans and securities perform through the stress scenario. The Fed expects banks to develop their own risk management plans and not copy those of the central bank.

Banks have told regulators they would cut their dividend and stock buybacks as losses mounted in a recession. However, the Fed will continue to assume in its modeling of losses and capital that banks continue with payouts because that is what they did in the past. The 19 largest banks paid out more than $43 billion in dividends in 2007 as the housing bubble began to burst, and an additional $39 billion in 2008 as financial markets plunged into turmoil, according to the Fed.

Too Blunt

Banks have said the Fed’s models are too blunt and don’t account for information they may have on borrowers. The Fed plans to continue with a standardized approach in part to show how banks look on a comparative basis.

U.S regulators are imposing the biggest capital regime change on the financial system since the 1988 Basel Accord as they execute mandates under the Dodd-Frank Act and international agreements phasing in higher capital and liquidity standards. Banking associations have warned that the new regulations could reduce lending or increase risk.

“Overly punitive rules that impose capital charges that do not reflect underlying risks create an incentive for banking organizations to generate more earnings through riskier activities to compensate for the higher level of required capital,” the American Bankers Association, The Financial Services Roundtable and the Securities Industry and Financial Markets Association said in a letter to regulators last month.

Close Scrutiny

The Fed said in its instructions that it would “closely scrutinize” capital plans that fail to demonstrate how the bank will make progress on capital guidelines stemming from the international accord known as Basel III.

Bank lending is increasing as the economy proceeds through its fourth year of expansion. Loans and leases at commercial banks in the U.S. rose at a 3.5 percent seasonally adjusted annual rate in the third quarter. Delinquency rates have fallen on credit card loans and commercial loans, while they remain high on residential mortgages.

House prices are still down 29 percent from a 2006 housing bubble peak, according to the S&P Case-Shiller 20-city home price index. Fed data shows residential mortgage delinquency rates of 10.6 percent in the second quarter compared with 1.62 percent in the second quarter of 2006.

High rates of past-due mortgages stem from an unemployment rate that remained above 8 percent for 43 months before dropping to 7.8 percent in September. The jobless rate last month was 7.9 percent.

Still, 10 out of 25 large banks generated returns on tangible common equity in excess of 15 percent, said Jason Goldberg, a senior analyst at Barclays Plc in New York. Earnings per share grew 18 percent on a year-over-year basis in the third quarter for the median bank in the group, and rose 5 percent from the second quarter, he said.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net

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