Morgan Stanley Must Resubmit Capital Plan in Fed Stress Test

  • Bank gets conditional approval as 30 other firms pass exam
  • Deutsche Bank, Santander units fail on ‘broad’ weaknesses

What the Fed Stress Tests Tell Us About State of Banking

Morgan Stanley was alone among the largest U.S. banks in stumbling through the Federal Reserve’s annual stress tests, getting conditional approval to increase payouts to shareholders. Thirty other firms passed, while two subsidiaries failed.

Morgan Stanley must shore up internal systems and resubmit plans for managing capital by Dec. 29, the Fed said Wednesday. Examiners again failed U.S. units of Deutsche Bank AG and Banco Santander SA, saying they suffer from “broad and substantial weaknesses” in how they manage capital. And one regional lender, M&T Bank Corp., passed only after adjusting its plan for shareholder payouts.

“Morgan Stanley exhibited material weaknesses in its capital planning,” the Fed wrote, listing deficiencies in how the firm designs specific scenarios, shortcomings in its modeling practices and related governance and control issues. “These weaknesses warrant further near-term attention but do not undermine the quantitative results.”

The annual review is a cornerstone of the Fed’s strategy to prevent a repeat of the 2008 financial crisis and taxpayer-funded bailouts by forcing the largest banks to bolster their operations with more capital. Wednesday’s results mark this year’s second and final round, determining whether firms can withstand losses and still pay dividends, buy back stock or make acquisitions.

The Fed’s findings unleashed a flurry of announcements from banks, with many saying they’ll significantly boost shareholder payouts.

Morgan Stanley said its quarterly dividend will increase 33 percent to 20 cents a share, or 2 cents more than estimated, and the company plans to repurchase as much as $3.5 billion of stock in the coming four quarters. The firm is committed to addressing the Fed’s concerns and can meet examiners’ requirements, Chief Executive Officer James Gorman said in a statement.

That’s “a really healthy buyback,” said Devin Ryan, an analyst with JMP Securities. “It’s not ideal to have the asterisk, but it is a strong buyback approval and I think investors will look past the fact that they have to resubmit.”

JPMorgan Chase & Co., the biggest U.S. bank by assets, kept its dividend at 48 cents and said it aims to repurchase $10.6 billion of stock, up from the $6.4 billion it announced last year. Citigroup Inc. said its dividend will more than triple to 16 cents -- a penny more than estimated -- while it buys back $8.6 billion of shares.

Morgan Stanley and JPMorgan climbed 1.3 percent in extended trading at 5:17 p.m. in New York. Citigroup gained 2.5 percent.

Changing Plans

Altogether, firms passing the tests planned to pay out about 65 percent of their projected earnings over the coming four quarters, a senior Fed official told journalists on a conference call Wednesday.

Last week, the Fed said all 33 banks subject to the tests have enough capital to absorb losses during a sharp and prolonged economic downturn, the second straight year all firms cleared the exams’ first stage. That review, which didn’t factor in capital plans, showed Morgan Stanley trailing the rest of Wall Street in a key measure of capital. The firm’s projected 4.9 percent leverage ratio tied for last place and fell within a percentage point of the 4 percent regulatory minimum.

Following those results, firms can modify their capital plans to ensure they don’t plan to pay out so much capital that it pushes their ratios below regulatory minimums. Regulators don’t hold it against companies if their original plans are so aggressive that they’re forced to resubmit, a senior Fed official said last week. Buffalo, New York-based M&T Bank was the only firm to do so this year.

Coming into this week, Bank of America Corp. faced what some analysts considered the most pressure to show that it could overcome stumbles in the past two years. The Fed had put the Charlotte, North Carolina-based lender on notice that it needed to get better this year, and CEO Brian Moynihan responded by allocating more than $100 million to overhaul controls. He also promoted veteran human-resources executive Andrea Smith to chief administrative officer, overseeing the stress-test submission.

The bank, like Citigroup, has paid penny and nickel dividends every quarter since the process began -- a fraction of what both firms doled out before the financial crisis.

Bank of America and Citigroup both passed the tests handily, with their common equity Tier 1 ratios remaining well above the 4.5 percent regulatory minimum even after distributing capital to shareholders. Bank of America’s figure dipped to 7.1 percent under a hypothetical economic shock, while Citigroup’s fell to 7.7 percent, according to the Fed.

Bank of America boosted its quarterly dividend 50 percent to 7.5 cents, short of the 10-cent estimate, and said it will buy back as much as $5 billion of stock. The shares rose 1.8 percent in extended trading.

“BofA was positive, certainly, but as a somewhat disappointed shareholder, I’d like it a whole lot better if it had gone to 10 cents a quarter rather than 7.5,” said Nancy Bush, an analyst who founded NAB Research LLC in New Jersey. “They’re trying to please all constituencies.”

Tough Scenarios

The Fed’s scenarios were seen as especially tough this year as they called for banks to assume -- in the most severe case -- that U.S. unemployment doubled to 10 percent while the markets tumbled and Treasury yields went negative. The banks would have experienced resulting loan losses of $385 billion, the Fed said last week.

In a lesser “adverse” event, the banks contemplated a minor U.S. recession and mild deflation, while a third was a baseline that tracked the average projections of economists. The scenarios also included some extra hardships for big trading firms, such as Morgan Stanley and Goldman Sachs Group Inc., as they had to assume market shocks and trading-partner woes on top of the other troubles.

Foreign lenders with large U.S. operations also are subject to the Fed’s test. Examiners credited Deutsche Bank Trust Corp. and Santander Holdings USA Inc. with making improvements this year after rejecting their submissions in 2015, but said the assumptions and analyses behind their plans still aren’t “reasonable or appropriate.” The regulator listed deficiencies at both businesses, including in risk management.

“The capital adequacy of Deutsche Bank Trust Corp. has never been in doubt,” Bill Woodley, deputy chief of the German lender’s Americas business, said in a statement. “We appreciate the Federal Reserve’s recognition of our progress, and we will implement the lessons learned this year in order to strengthen our capital planning process.”

This year’s review also raised concerns among examiners that the biggest banks need to bolster auditing systems that identify weaknesses in capital planning. The Fed plans to conduct a more thorough review of those operations in the months ahead.

“Buried in the fine print, they are saying there is still more work to be done,” Michael Alix, a partner at PwC and a former senior official at the Federal Reserve Bank of New York, said in an interview. “They don’t want them missing the forest for the trees.”

Next year’s tests may be even tougher. Fed Chair Janet Yellen said in congressional testimony this month that the stress-test process is about to undergo “meaningful changes.” She underlined plans recently announced by Fed Governor Daniel Tarullo that would impose a higher capital target on eight of the largest firms, while giving mid-size banks a break from certain assessments of whether lenders adequately track their market risks.

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