Biggest Banks Pass Fed’s Stress Tests

The nation’s biggest banks are strong enough to continue lending if the economy plunges into a severe downturn, an assessment by the Federal Reserve on Thursday that could fuel Wall Street’s calls to further relax financial regulations.

The results of the first phase of the Fed’s annual “stress tests” showed that the country’s banks have more than enough capital to survive the combination of a recession, cratering of housing prices and double-digit unemployment.

The banks are riding high thanks to tax cuts and recent moves to soften regulations. They are eager to return more of their profits to shareholders, and the test results suggest regulators will give many the green light to pay dividends or buy their own shares next week.

Still, two Wall Street giants — Goldman Sachs and Morgan Stanley — came close to falling short on one of the Fed’s financial-health gauges. That could complicate their plans to pay dividends and repurchase their shares.

The ability of most banks to ace the tests is an indication of how far Wall Street has come since the financial crisis. A decade ago, bad bets on the housing market crippled the industry and led the government to bail out hundreds of banks.

To prevent a repeat of those taxpayer-financed rescues, the Fed now requires banks to maintain capital cushions that would allow them not only to stay afloat but also to keep lending during periods of intense financial stress. Since 2009, the 35 banks that underwent the tests have added about $800 billion in the highest quality type of capital, the Fed said.

The Fed’s annual simulation tested 35 of the largest banks, including the United States units of several foreign firms. Under the Fed’s “severely adverse scenario,” which envisions the economy rapidly sinking into a recession, banks would suffer losses totaling $578 billion, but they would still have enough capital to stay above the minimum levels required by the central bank.

“Despite a tough scenario and other factors that affected this year’s test, the capital levels of the firms after the hypothetical severe global recession are higher than the actual capital levels of large banks in the years leading up to the most recent recession,” Randal K. Quarles, the Fed’s vice chairman for supervision, said in a statement.

This is the second straight year that all the big U.S. banks were found to have enough capital to withstand a hypothetical recession. In 2017, the banks sailed through the first round of the stress tests, and, a week later, the Fed approved all 34 banks’ plans to return money to their shareholders.

This time around, though, Goldman and Morgan Stanley might need to adjust those plans. Both Wall Street firms came perilously close to falling below the Fed’s minimum level on a key metric, the so-called supplementary leverage ratio. It is intended to measure the ability of banks to withstand severe economic distress, and the test punishes companies for a heavy reliance on borrowed money and for exposure to assets that are not on their balance sheets.

The Fed requires large banks to maintain a supplementary leverage ratio of at least 3 percent of their assets and certain other positions. Goldman’s ratio was as low as 3.1 percent under the stress tests, while Morgan Stanley’s lowest was 3.3 percent. (Under a separate measurement in the tests, Goldman had a 5.6 percent capital ratio, and Morgan Stanley’s was 7.3 percent, safely above the Fed’s 4.5 percent minimum.)

Those low ratios mean the two banks might have to reconsider how much money they want to return to shareholders in the form of dividends and share buybacks. Next week, the Fed will run a more consequential round of stress tests, known as the Comprehensive Capital Analysis and Review, in which the regulator will decide whether banks are sufficiently strong and well-managed to warrant their dividend and buyback plans.

In a statement on Thursday, Goldman said its own of forecasts of how its capital levels would fare during downturns came up with different results than the Fed. The bank said it planned to discuss the divergence with the Fed before next week’s test.

Morgan Stanley said in a statement that Thursday’s results “may not be indicative of the capital distributions that we will be permitted to make.”

Wells Fargo, which has faced a series of regulatory penalties stemming from its sales practices, was among the banks to easily clear the Fed’s hurdles. Its key capital ratio was 8.6 percent, above the Fed’s 4.5 percent minimum. That was the highest among the country’s five largest banks, as measured by assets.

Other large banks weren’t far behind, with Bank of America, Citigroup and JPMorgan Chase showing that their capital ratios would have held above 7 percent under the Fed’s worst-case economic scenario.

While the results are likely to cheer bank executives and shareholders, skeptics cautioned against regulators responding to the strong performances by watering down safeguards against future crises.

“This just shows that regulators’ models are saying that you have OK capital. But guess what, regulators’ models said before the financial crisis that you had OK capital, too,” said Marcus Stanley, policy director at Americans for Financial Reform, an advocacy group that pushes for tougher financial regulation. “I don’t think that this is telling us that everything is OK and we don’t need to be vigilant.” The strong results are likely to give banks more momentum to lobby to further relax regulations. Banks already have successfully pushed the Fed to relax the so-called Volcker Rule, which bars banks from trading with depositors’ money. Congress recently passed a law to peel back some regulations aimed at small and medium-sized banks, which prompted the Fed to drop three financial institutions — CIT Group, Comerica and Zions Bancorporation — from the stress tests.

Republicans in Congress and regulators in the Trump administration appear open to more changes. Fed officials have stressed that they want to keep the architecture of the post-crisis regulatory regime, while improving it in particular for smaller financial institutions.

“The financial system all but failed 10 years ago,” Fed chairman Jerome H. Powell said in a news conference this month. “We went to work for 10 years to strengthen it, stronger capital, stronger liquidity, stress testing, resolution planning. We want to keep all that stuff. We want to make it, you know, even more effective and certainly more efficient. We want to tailor those regulations for institutions.”

Banks are in the midst of an era of extraordinary profits, fueled by the strong American economy, record low unemployment and rising interest rates, which are a key source of bank profits.

The Republican tax cuts have also saved 26 publicly traded banks a total of more than $11 billion this year, according to Just Capital, a nonprofit research group. More than half of that has gone to shareholders in the form of dividends and share buybacks.

The biggest banks have said the tax cuts, which slashed the corporate rate to 21 percent from 35 percent, will lower their effective tax rates considerably. JPMorgan Chase and Wells Fargo have both said the new law should reduce their tax rates next year to 19 percent, down nearly one-third from what they paid in 2016.

“The banking system usually looks at its greatest health at the top of an expansion,” said Kim Schoenholtz, a professor of the history of financial institutions and markets at New York University’s Stern School of Business.