Stress tests show how Fed pushed on balance sheets

March 14 (Bloomberg) -- The resilience of the largest U.S. financial firms when tested against a recession more severe than the last one shows regulators have succeeded in pushing banks to build fortress-like balance sheets.

The Fed yesterday said 15 of 19 banks would be able to maintain capital levels above a regulatory minimum in an “extremely adverse” economic scenario, even while continuing to pay dividends and repurchasing stock. Those results were due to scrutiny by the Fed on capital payouts over the past three years, the central bank said.

Regulators, empowered by the Dodd-Frank Act and goaded by criticism for failing to spot the subprime mortgage debacle, have redesigned their approach to bank supervision. They now place greater emphasis on systemic risk as they seek to avoid a repeat of the crisis that resulted in a $245 billion taxpayer bailout of banks through the Troubled Asset Relief Program.

“Any bank that remains adequately capitalized under these acute stress scenarios is not just strong but also darn-near impregnable,” said Karen Shaw Petrou, a managing partner at Federal Financial Analytics, a Washington research firm, whose clients have included Wells Fargo & Co. “What’s a bank for is at the heart of this question: Is it to be Fort Knox?”

JPMorgan Chase & Co. and Wells Fargo joined banks raising dividends and authorizing share repurchases after passing the stress tests. Citigroup Inc., the lender that took the most government aid during the financial crisis, said it will resubmit its capital plan to regulators after failing to meet some minimum standards in the tests. Citigroup has repaid $45 billion in TARP money.

Falling Short

SunTrust Banks Inc., Ally Financial Inc. and MetLife Inc. also fell short by at least one measure under the central bank’s worst-case scenario. Ally also intends to resubmit its plan, the company said in a statement.

Stocks rose, sending the Dow Jones Industrial Average to the highest level since 2007, after the JPMorgan Chase said it will increase its quarterly dividend 20 percent and as the Fed raised its assessment of the economy.

The Standard & Poor’s 500 Index added 1.8 percent to 1,395.95 at 4 p.m. New York time yesterday, and the Dow climbed 217.97 points, or 1.7 percent, to 13,177.68. Yields on 10-year Treasuries advanced a fifth day, reaching 2.13 percent.

The KBW Bank Index, which tracks shares of 24 of the largest U.S. banks, rose 4.6 percent. The index is up 21 percent this year on expectations of stronger economic growth and improving profits. Concern that the nation’s banks may be damaged by Europe’s debt crisis helped drive down the index 25 percent in 2011, its worst annual performance since 2008.

Adequate Capital

The Fed tested the banks to ensure that they have adequate capital to continue lending in a downturn. The test assumed an unemployment rate of 13 percent -- compared with a peak of 10 percent as a result of the 18-month recession that ended in June 2009 -- a 50 percent drop in stock prices and a 21 percent decline in house prices. It showed that those circumstances would produce aggregate losses of $534 billion over nine quarters.

Even with such a blow, the 19 banks would see their Tier 1 common capital ratio -- a measure of bank strength against loss -- fall to 6.3 percent in the fourth quarter of 2013, above the 5 percent minimum the Fed required. The ratio was 10.1 percent in the third quarter of last year.

‘Very Onerous’

The fact that most of the banks came through “this very onerous stress test” demonstrates “the strength of the U.S. banking system,” Gerard Cassidy, an analyst with RBC Capital Markets, said in an interview.

European banks’ reluctance to lend to one another fell yesterday to the lowest in seven months. The Euribor-OIS spread, the difference between the euro interbank offered rate and overnight indexed swaps, declined to its lowest since Aug. 5.

Banks are “much better capitalized” than during the 2008 financial crisis and “understand their balance sheet and loan portfolio much better,” said Paul Miller, a former examiner for the Federal Reserve Bank of Philadelphia and analyst for FBR Capital Markets in Arlington, Virginia.

Bankers criticized the criteria the Fed used in the stress tests.

Frank Keating, president and chief executive officer of the American Bankers Association, said he objects “to testing bank capital under theoretical conditions that are far more severe than even those seen during ‘the Great Recession.’”

Ally Financial said in a statement that the central bank’s “analysis dramatically overstates potential contingent mortgage risk, especially with respect to newer vintages of loans.”

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