Here’s Your Guide to Playing a New Round of Fed Stress Tests Coming On 34 Large Banks

Dividend-focused investors in large bank stocks will need to pay careful attention over the next couple weeks as the results of annual stress tests on the largest 34 financial institutions with at least $50 billion in assets, and their capital distribution plans, are released.

 The Federal Reserve is asking the largest banks to make sure they have sufficient capital buffers to withstand a hypothetical “severe global recession” in which the unemployment rate rises by 5.25% and peaks at 10% by the third quarter of 2018 while equity prices fall by 50% through the end of 2017. The goal is to ensure that the largest U.S. banks can survive a financial crisis similar to the one that shook up the global economic in 2008.
The central bank has scheduled to have stress tests, required by the Dodd-Frank Act, written in the wake of the crisis, to come out Thursday, June 22. Roughly one week later on Wednesday June 28, another series of stress test results will be distributed by regulators that will let the institutions know whether the central bank has approved their capital distribution plans, which include dividends and stock buybacks.
While most are expected to do well and be allowed to increase their capital distributions to shareholders some may have to cub their plans based on the hypothetical future scenario.
“We’re not expecting any of the banks we cover to have any quantitative failures this year,” said Brian Klock, analyst at Keefe, Bruyette & Woods. “Most banks will be approved for increases in buybacks and dividends.”
Investors should pay particular attention to the second set of test results, which are expected to be distributed after the market closes at 4:30 p.m. on June 28 because that is when they will release their dividend and stock buyback plans for the upcoming year (unless some are leaked earlier, which is a possibility).
Banks are expected to privately receive a preliminary decision on whether their capital distribution plans are approved or rejected this week, according to person familiar with the situation, depending on whether they do well on the test or not. At that time, if their plans are not approved, they have one chance to revise their distribution plans downwards as part of an effort to make sure their final plans are approved by the June 28 release date for the second set of tests dubbed the Comprehensive Capital Analysis and Review, or CCAR. Last year M&T Bank Corp. an institution with a stronger capital buffer and positive loan portfolio, had to  its previous ambitious distribution plan during the review period.
Most banks are expected to pass the first set of tests and any that fail will typically be allowed at most to keep only the same low level of capital distribution as the year before.
This year the only new entrant to the tests is CIT Group Inc., which officially joins after participating privately in 2016. It became large enough to be subject to the review after closing a $3.5 billion deal to buy OneWest Bank in 2015. CIT Group revealed in July last year that the central bank had privately given it a “qualitative objection” in a preliminary test over concerns around risk management. As a result, CIT Group was only permitted to issue modest buybacks over the past few quarters.
Beyond CIT Group, investors should watch for whether big banks get in trouble with the qualitative component in the second round of the tests. So-called “qualitative deficiencies” are problems with internal controls or issues with projections made by internal company-run exams. The biggest banks, including Bank of America Corp. , JPMorgan Chase & Co , Wells Fargo and Citigroup Inc. will all still need to undergo qualitative reviews. And some of them, including Citigroup and Bank of America, have had trouble with this component of the review in the past.
Passing the Dodd-Frank stress test doesn’t really provide any significant indication of how they will do on the capital distributions because the two tests have different metrics for success. The Dodd-Frank test only considers the capital distributions each bank has made over the past four quarters while the CCAR is more forward looking and considers what stock buybacks and dividends each institution wants to make over the four quarters starting in July.
Expect most if not all of the banks to be above the minimum financial ratios required by the Dodd-Frank Act. However, look for some the minimum requirements. For example, last year, Morgan Stanley , BMO Financial Corp. Huntington Bancshares Inc.  and KeyCorp. all came close to dropping below the threshold.

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