US Banks 2017 Stress Test: All pass = Higher payouts
The US Federal Reserve (Fed) released on 28 June the results of its Comprehensive Capital Analysis and Review (CCAR), an annual exercise to evaluate the capital planning process and capital adequacy of large bank holding companies. The results of the Dodd-Frank Act stress test (DFAST), a component of the central bank’s stress test, was announced on 22 June. The stress tests gauge not only capital strength of the nation’s largest financial institutions (total consolidated assets of USD 50 bn or more) but also their ability to lend to households and businesses during a severe recession.
The US Fed recently amended rules to exempt large and non-complex banks from the 2017 CCAR qualitative assessment exercise, a sign that the US administration is reducing the regulatory burden. Subsequently, only 13 (out of 34) banks participated in the 2017 CCAR qualitative evaluation. The supplementary leverage ratio (SLR), another key capitalisation parameter, was also added to the stress test. Under the Fed’s capital regulations, bank holding companies are required to maintain at least 3% SLR ratio (tier I capital divided by total leverage exposure, which includes both on and off-balance sheet items) from 2018.
For the first time since the stress tests were launched (in 2011), the Fed approved all the 34 participating banks’ capital plans. Only two banks faced hiccups in the CCAR: (a) American Express – received approval after it submitted a revised capital plan after the DFAST results and (b) Capital One Financial – given a conditional approval due to weaknesses in capital planning practices; it has been asked to address the shortcomings and resubmit a capital plan by 28 December 2017.
The following conclusions can be drawn from the 2017 CCAR: (1) there has been a significant improvement in aggregate common equity capital to risk-weighted assets ratio to 12.5% as of 4Q16 vs. 5.5% in 1Q09; (2) under a severely adverse scenario, CET I capital ratio and SLR would decline to a minimum of 7.2% and 4.4% over the planning horizon. This is well above the minimum regulatory requirements of 4.5% and 3%, respectively. Overall, the US Fed’s approval of participating banks’ capital plans suggests that US banks are comfortably capitalised. The regulator also seems comfortable with the distribution of surplus capital.
The approval of the US banks’ capital plans resulted in the announcement of dividend payout and share buyback programmes which exceeded the elevated street expectations.
US banks have increased their dividend payout and share buyback by ~30% and 80% (average), respectively. This implies a total payout ratio of ~100% in 3Q17–2Q18, the second-highest level over the past two decades. Near term, we believe shareholder returns may well be a major investment driver for the US banking sector.
Overall, we have a preference for large-cap banks* thanks to their diversified business model and major contribution to capital returns increase (~80% of the USD 40 bn increase). Citigroup is our top-pick. The bank’s CET I and leverage ratios (under a severely adverse scenario) were well above regulatory requirements and peers’ average. It also increased its quarterly dividend payout by 100% and share repurchase programme by ~51% for 3Q17–2Q18. In our view, the strong performance in the 2017 CCAR and expected improvement in profitability (due to increase in shareholder returns) would drive a re-rating of Citigroup’s valuation.
*: Large-cap banks in the US: Bank of America, Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley and Wells Fargo
Data & recommendations as of 10 July, 2017 close
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