Tag Archives: stress test

(Revised) Hail to the Banking System

Each year, the Federal Reserve test that determines whether a large bank can withstand an economic slump. If a bank passes this test, then it is considered resilient in the event of negative economic activity. It is like a stress test. This story is covered by both the Wall Street Journal and the Washington Post.

After conducting the test, 29 out of the 30 big banks passed this test. Zions Bancorp was the only bank that did not pass this test. This means two things. One, it would probably be a good idea to invest with someone else other than Zions Bancorp. Second, this means that people can trust the banking system with their assets. The Financial Crisis of 2008 did involve the failure of a large bank, Lehman Brothers Holdings. Thomas Donahue, the chief of the U.S. Chamber of Commerce praised the banking system on CNBC. He does not agree with common grievances against banks. Banks have paid back their debts to the federal government plus the interest. It is true that there have been a few bad apples in the banking system, such as Bernie Madoff, but that does not mean that this industry cannot be trusted. People cannot distrust the entire banking system just because there have been a few people who ruined people’s lives with it.

I believe that people cannot believe everything that they read in the media. The banking system is very trustworthy. Sure, there have been some bad people in the past, such as Jordan Belfort or Mark Hanna. However, it is important to know that banks take legality very seriously, as do FINRA and the SEC. My father used to work in financial law enforcement, and now he works in anti-money laundering with Goldman Sachs. It is his job to prevent his company from doing business with anyone who’s money is not clean. In other words, he helps keep Goldman out of trouble. He also helps prevent insider-trading. His company takes compliance very seriously. He is a reason why we can trust the banking system. He helps ensure that money is being handled ethically and legally.

If the government supports the banking system, what reason do we have not to? The banks have paid back their debts and the interest. Furthermore, the government is testing their resiliency in the event like what happened in 2008. The banking system is a trustworthy industry, and anyone who says otherwise needs to do a little more research.

 

(Revised) Citigroup in the Hot Seat

On March 24th, I wrote a post about’s the Fed’s stress test. 29 out of 30 banks passed the test, but the bank that fell below the Fed’s standards was Citigroup. To re-summarize what the stress test actually is- the Fed takes each particular bank’s balance sheet and puts it through a rigorous simulation involving high inflation and severe unemployment. The first portion of the test involves quantitative measures such as leverage ratios, capital levels, and other quantitative measures that test whether the bank can withstand an economic shock. From here, the Fed checks the bank’s capital levels over time. Each bank later proves itself to the Fed through a qualitative test, which measures how the bank would pay dividends and manage capital given that the economy is operating in a recession.

Since the Fed gave its decision on Wednesday, shareholders are not happy because Citi will not be receiving the Fed’s permission to increase dividends and share buybacks. Shareholders reacted by selling Citigroup stock, which is now down about 4%, falling $2.71 to $47.45. Mentioned in WSJ, one portfolio manager at a hedge fund “said he liquidated his Citi holdings after the failed stress test. The investor said he was frustrated because he had had discussions over the past six months with Chief Financial Officer John Gerspach and members of the bank’s investor-relations team, and had been reassured that the bank’s relationship with regulators ‘was improving every single day,’ the investor recalled”.

However, it seems that Citigroup’s capital levels aren’t the actual problem. Their capital levels were actually above the Fed’s minimum threshold of 5% (during the simulated economic recession)- at 6.5% to be exact. The concern was that Citigroup failed the second portion of the test, in which the bank failed to sufficiently prove to the Fed how it would successfully manage capital through a recession. Another reason why the 2014 test was such a big concern was because Citigroup failed to pass the 2012 stress test as well. Even though Citigroup passed the 2013 test, the Fed notified the bank that they needed to refine their risk models and loss estimates. Apparently, Citigroup underestimated its projected losses by about $15 billion in 2013.

Since the 2008 financial crisis, the second portion (qualitative portion) has became much more important. It measures how the bank would actually manage a recession, incorporates past lessons and concerns, takes into account how a bank handles its technology, and also tests how it would handle costly litigation. In my opinion, I think the Fed stepping up their game is a great thing. Even though banks may not like the tightening in regulation, it sends the message that banks need to step up their game as well. For the most part, the Fed is seeing good results. This is evident through 29 out of 30 banks passing the test and according to the WSJ article, banks have more than doubled capital levels since 2009. I think that the market’s perception is what’s most important. Even though Citigroup has ample capital, it needs to convey to its share holders that it can manage this capital throughout a recession. Although the first portion of the stress test is important, the second qualitative portion is what’s practical and relevant for shareholders.

In recent news, the topic of Citigroup failing the Fed’s stress test has become even more controversial. After reading more on the topic, my opinion of the test has also changed. Given that the test was only created in 2009 after the financial crisis, it is still an its nascent stages. Apparently, the portion of the test (qualitative portion that measures banks’ predictions about losses under stressed conditions) that Citigroup failed is considered a “building block” of the test. The Fed is still improving this portion of the test and commented that many other banks have “work to do” in these areas. According to Mr. Corbat, CEO, he believed that the bank had settled with the Fed a 2015 timeline. However, the Fed judged that Citi hadn’t made enough progress on the issues that required more attention. I think that a reason for this may be that Citigroup also failed the stress test in 2012, so the Fed may have kept this in mind while basing their decision. This also brings up the issue of the Fed incidentally failing one bank just to prove to investors that the test is actually valid- given that the stress test is still in its early stages. Also, we’ve seen asymmetric information involving the stress test in 2012 when JP Morgan publicly disclosed its stress test results before the Fed released results for all banks. Thus, their stock went up 7%, other banks were furious, and the Fed attributed the situation to a “miscommunication”. After reading more information about the actual validity of the stress test, Citi seems as if it wasn’t as worse off as the Fed projected it to be. Effectively, we cannot ignore that they still passed the capital level requirement. It seems to me as if this was a scenario where Citigroup received the short end of the deal on a test that still needs work.

Citigroup’s Stress-Test Mess

After the most recent series of bank stress test results released by the fed this week, several banks faced greater scrutiny over their financial practices. Out of 30 banks tested, five banks, including Citigroup Inc., Zions Bancorp, and the U.S. units of HSBC Holdings PLC, the Royal Bank of Scotland Group PLC, and Banco Santander SA did not receive the FED’s approval. Citigroup Inc. in particular faced the largest setback after the Federal Reserve rejected the bank’s proposal to reward investors with higher dividends and stock buybacks. According to the Wall Street Journal, the bank’s second rejection in three years was the result of the bank’s deficiency in it’s ability to project revenue and losses under stressful scenarios in parts of the firm’s global operations. This comes even after the results showed that Citigroup’s Tier 1 common capital ratio was above regulatory thresholds, and at 6.5% above many other banks that did receive approval.As the Fed pointed out, this rejection was based on qualitative problems with the stress tests, such as with internal risk management which oversees tasks including financial risk audits and organizational risk assessment. At the end of the day, while the quantitative measures looked good on paper, the Fed did not appear satisfied with the level of safety and foresight Citigroup has shown in the past few years after the financial crisis. As a result, Citigroup and the other four banks must submit revised capital plans and suspend any increased dividend payments, the latter of which will likely cause disappointment to shareholders.

While Citigroup’s rejection certainly is not a great outcome for the bank, as it may damage its reputation and credibility as a lender and insurer. And it’s certainly an embarrassment because this recent development makes Citigroup only the second bank, aside from Ally Financial, to have its capital plan rejected twice by the Federal Reserve. But overall it isn’t necessarily a bad thing for the firm. First, the firm has a strong store of capital set aside, which could act as a buffer in case of a strong negative shock to unemployment or the stock market. Second, Citigroup’s rejection is a signal by the Fed that the firm needs to correct perceived deficiencies in its operations. Like in a first submission of an article to an academic journal, the Fed, like the peer reviewer, can send back Citigroup’s capital plan with harsh critiques, edits, and an outline of the necessary requirements. This may serve to point out potential problems in risk management or governance that Citi had previously missed. Since these problems may eventually hurt the firm down the line, if uncorrected, it’s in Citigroup’s best interest to, like an academic economist, take the critiques with a grain of salt and use them to form a plan to fix the company’s risk management. This may mean a reorganization of managers and executives, and the employees in the deficient departments may face layoffs, but if Citi can fix their deficiencies they may come out of this a healthier company.

On the other hand, the people who will face the most problems as a result of the Fed’s rejection are the shareholders (Citigroup’s stock fell 5% after hours today), and the firm’s new CEO Michael Corbat. As a consequence of Citi’s failed capital plan, it has been refused the ability to raise its dividend, which currently sits at a quarterly penny-a-share, and to engage in a share buy-back program. This doesn’t bode well for Corbat, since pleasing shareholders is one of the main goals of a modern CEO. The inability to issue a dividend means that the shareholders won’t be rewarded directly, and the inability of Citi to issue a stock buyback means that shareholders won’t enjoy the benefits of “concentrated” stocks (after a buy-back a shareholder will essentially own a larger share of the company). And the lack of confidence by the Fed in Citi’s risk procedures may make investors wary of the company in the near future, meaning that the company may face negative returns in the shortrun, which may further agitate some shareholders. Overall, this is hardly a pleasant start for the new CEO.

 

 

Fed’s Stress Test

Things are looking up for big banks. The Federal Reserve’s annual “stress test” of big banks’ financial health showed that the largest US firms are strong enough to survive a severe economic downfall. 29 of 30 of the largest institutions have ample capital to continue lending through a hypothetical economic downfall lasting to 2015- a downfall being defined as a severe drop in housing prices and unemployment.

The Fed’s annual “stress test” is designed to ensure that large banks can survive big losses during economic downtimes. These stress test results will be critical for the Fed’s decision next week to approve or deny each banks’ plans for giving billions of dollars back to shareholders through dividends or share buybacks. However, performing well on this stress test is not an outright guarantee of a bank’s survival because the Fed also considers more subjective measures such as the strength of a bank’s internal risk management.

The Fed’s recessionary stress test scenario used was a rising unemployment rate, a steep drop in housing prices, and a 50% decline in stock prices over nine quarters. The baseline that they used to measure whether each bank would survive is a minimum tier 1 common capital ratio of 5%. The Tier 1 common capital ratio is a measure of a bank’s financial strength in that it measures a bank’s core equity capital compared with its total risk-weighted assets. If the bank is over the 5% threshold, it should be able to increase dividends or buy back stock. The graph below shows the banks that could have survived the test in 2013 versus the banks that could have survived now in 2014. Surprisingly, many of the larger well-known banks ranked near the bottom of the pack. “The six biggest banks earned $76 billion in 2013, just $6 billion shy of their collective all-time high. All U.S. banks earned a record $154.6 billion, according to data compiled by SNL Financial. Some of the biggest financial institutions, including Bank of America Corp. BAC -2.01% and Morgan Stanley, MS -0.58% haven’t boosted dividend payouts since the financial crisis.”

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In my opinion, I believe these results are good for investors because banks will be able to reward them by raising dividends and buying back shares in the near future. In the scenario where there would be a 2015 economic downfall- even though the current housing market looks somewhat stable, it’s also good news to know that we have a bit of a security blanket if the unemployment rate were to keep ticking up.

Where are we on recovery?

Has U.S. economy been recovering in the right path? This has been the million dollar question, or rather, the trillion dollar questions for everyone. Since 2008 and the great recession, there has been a lot of hurdles in the way like the high unemployment, low inflation rates or other negative exogenous events including the Euro Financial Crisis and the recent heightened tension in Russia that caused worries in the market.

If you look at my past posts, there were some consistencies in few series that the Fed and the government is indeed moving towards adjusting their position for recovery path. The Fed’s continued tapering, increase in minimum wage for federal workers and switching interest rate hike threshold from unemployment rate to the tapering amount.

I want to introduce another sign that may point to US recovery is indeed on path. The Fed has announced that 29 of the 30 top tier banks passed the stress test in the case of a big shock in the market. This has multiple implications. First and very simple implication is that finance sector, which caused the big hassle for all of us, has come to be more stable. Second is that individual banks may be able to give back billions of dollars to its investors in dividends and buyback outstanding share. This is particularly important because dividend payouts and share buybacks for banks require Federal Reserve’s approval. Although this auditing and approval may be more subjective to each banks, 29 top tier banks passing the test may be sound news for investors looking for gain of confidence in the market.

The stress tests are made to prevent any future crisis like that of 2008. It took $700 billion dollars worth of taxpayers’ bailout program to bring back what was left of the melt down. It looks at banks’ current financial health like capital ratios, revenue and loss rates under different scenarios compiled by the Fed. One that does not pass the test has a high chance for not being approved for dividend payouts.

One of the main fundamental things that we should be aware of is the amount of capital that is available for the depositors in case of a panic attack. Think back to the great depression where everyone made a run to the bank to withdraw deposits. Because banks were not able to provide everyone with their money.

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Look at the great recession and the great depression period on the graph. There was a large deflationary movements along the graph. Now, the Fed wants to assure that there is enough capital for banks to endure higher degree severe events.

Lest to say that this is a perfect protection sign for the financial industry, but it is sure a sign of good recovery.