U.S. banks seeking regulatory approval to boost payouts to shareholders next year will face a new hurdle as the Federal Reserve begins making its own projections for lenders’ balance sheets in annual stress tests.
The Fed, using its own model for how banks will fare in an economic slump, may project lower capital ratios for the nation’s largest lenders than what the firms calculated, according to a letter issued yesterday by the central bank. That’s because Fed estimates will rely on historical data showing industry assets rose in the last three recessions. In past tests, the examiners used bank estimates that typically predicted a drop in asset balances, according to the letter.
Companies’ projections for a decline in loans or total assets would be “at odds with historical experience,” the Fed wrote. If examiners’ figures are significantly higher than the banks’, “the associated pro forma capital ratios will be lower.”
Regulators, intent on preventing a repeat of the 2008 credit crisis, run annual stress tests to see how the largest lenders would fare in a recession or economic shock. If banks can’t demonstrate their ability to maintain capital buffers while weathering hypothetical turmoil, the Fed can reject the companies’ proposals for dividends and share buybacks.
Capital ratios are calculated by dividing a measure of shareholder equity by assets weighted by their riskiness. If asset balances increase rather than shrink, all else being equal, banks would need more capital to keep ratios constant.
In addition to asset balances, the Fed will use the balance-sheet estimates to project pre-provision net revenue, loan losses and other figures, according to the letter. The new approach also may affect the equity portion of the capital ratios, because higher asset balances can influence revenue, according to the letter.
In March, the Fed approved capital plans for 16 of the 18 largest U.S. banks, as most lenders showed they could navigate a deep recession with a Tier 1 common ratio of more than 5 percent. Detroit-based Ally Financial Inc.’s resubmission was approved last month, while BB&T Corp., based in Winston-Salem, North Carolina, got Fed approval in August.
Most banks subject to the next test could pay out more than their estimated net income over the four quarters ending in March 2015 and still pass, Goldman Sachs Group Inc. analysts led by Richard Ramsden wrote in a note this month. The largest “money-center” banks will probably pay out a lower ratio of net income as buybacks and dividends than regional lenders or trust banks, the analysts wrote.