Finance

Michael P. Regan is a Bloomberg Gadfly columnist covering equities and financial services. He has covered stocks for Bloomberg News as a columnist and editor since 2007. He previously worked for the Associated Press.

The top banks operating in the U.S. just received their report cards from the Federal Reserve, and it doesn't look as if any of them will have to go to summer school. 

Bringing Up the Rear
Morgan Stanley came the closest of all the big banks to the Fed's minimum leverage ratio under its worst scenario, but the bank's shares still rose in after-hours trading
Source: Bloomberg

All 33 banks required to undergo the Fed's stress tests came through the exercise without falling below required capital levels even under the most nightmarish scenarios outlined by the Fed. In fact, in most cases they were well above the required levels. Perhaps the closest thing to a cause for alarm was Morgan Stanley’s projected 4.9 percent leverage ratio, which along with BMO Financial's U.S. unit, came within one percentage point of the required 4 percent minimum, as Jesse Hamilton and Dakin Campbell reported. But Morgan Stanley is rallying in after-hours trading, so even this scrutiny is probably a little nitpicky. 

Surviving the Stress
All big banks passed the Fed's stress tests with more than enough capital to withstand a hypothetical "severely adverse" economic shock
Source: Federal Reserve
Note: Shows selected banks' minimum levels for two of four capital ratios tested under the Fed's "severely adverse scenario."

In sum, the results should further inspire confidence in the banking sector's ability to withstand another crisis -- as well as inspire confidence that many banks will be able to increase dividends and buy back more shares. It's estimated that the six biggest U.S. lenders will probably return more than $60 billion to shareholders, up from about $50 billion in the four quarters ending this month, according to CLSA Ltd. analyst Michael Mayo's math.

The knee-jerk verdict from the stock market, for whatever that's worth, seems to be approval. Citigroup and Bank of America were posting gains of more than 2 percent in extended trading after each rallied more than 3 percent in regular trading. The lack of much profit-taking in after-hours trading is notable, considering all 24 stocks in the KBW Bank Index surged at least 2 percent on Thursday as investors -- rightly or wrongly -- grew more comfortable with the notion that Britons would vote in favor of remaining in the European Union. 

There is reason to believe that, due to the unpredictable nature of financial crises, there is no 100 percent accurate way to model how banks will fare in the next one. (The current risk of a Brexit that consumed the attention of financial markets this month, for example, was not a crisis that banks were asked to model.) But that shouldn't serve as a reason not to attempt it.

And make no mistake, these stress tests were no pop quiz. The passing grades come even amid what the Fed projected would be loan losses of $385 billion over the nine quarters tested as banks endured a hypothetical recession that pushed the unemployment rate up to 10 percent and sent short-term Treasury yields negative. (Hmm, kind of sounds like the Fed is worried the U.S. will turn into Europe, doesn't it?) It envisioned an economic crash that sends gross domestic product shrinking by 6.25 percent, house prices dropping 25 percent, commercial real estate prices plunging 30 percent and a whole raft of other calamities. 

Attention now will turn to next week's analysis of the banks' plans for dividends and share buybacks and whether they are too ambitious under this nightmare scenario. The big question is whether any bank will need to use a "mulligan" -- a golf term for taking a second tee shot after messing up the first one -- and reduce their capital-return requests 

"In recent years, the banks' fear of a stigma associated with the use of the mulligan appears to have faded, and in our view its use can be interpreted two ways," Sanford C. Bernstein analyst John McDonald wrote in a note to clients before the results were released. "If the mulligan is used because the company has far less cushion to minimums than expected, that's a clear negative (since capital return will be smaller), while if the mulligan is used because management tried to max out capital return and needs to ratchet it down a bit to avoid a breach, that could be interpreted as positive (e.g. 'they really went for it')." 

Based on an initial look at these results, the only banks that will need to take mulligans will be those that were trying to drive the green in the first place. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Michael P. Regan in New York at mregan12@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net