Last week, it was announced that the results of the first round of the Federal Reserve’s annual “stress tests”—which evaluate whether U.S. banks have enough capital to withstand a financial crisis—were positive: All 33 U.S. banks passed the “warm up” stress tests, signaling that they could, hypothetically, withstand an estimated $385 billion in losses should a recession occur.
But the second round of results—released just after markets closed on Wednesday—were less promising. The second part of the stress tests are closely watched by banks and investors, since passing or failing dictates whether a particular bank is allowed to increase the amount of money it returns to shareholders in the form of dividends or share buybacks. This year, the Fed failed two banks: the Deutsche Bank Trust Corporation and Santander Holdings USA. Both are subsidiaries of European banks and both failed last year as well. This marks the third consecutive year Santander has failed.
The annual Fed stress tests were created after the financial crisis as a means of evaluating whether banks have enough of a financial cushion to absorb losses if a crisis was to occur. The aim is to prevent bank failures in the future. Under Dodd-Frank reforms, banks with more than $50 billion in assets are required to submit to the Fed detailed plans for dealing with various financial risks. After a careful evaluation, regulators decide whether a bank has passed or failed.
Morgan Stanley passed the test, but narrowly. The American bank is required to re-submit their plan by the end of the year “to address certain weaknesses in its capital planning processes,” in the words of the Fed. Bank of America and Citigroup, two banks that have struggled with passing the stress tests in the past, both passed.
According to the Fed, U.S. banks have doubled their capital and added more than $700 billion of equity capital since 2009. The results of the stress tests have been made public since 2012, and failure means the Fed has deemed its risk-management subpar. Stress tests can have implications for bank executives as well: After the Fed failed Citigroup in 2014, its CEO Michael Corbat put his job on the line if the bank were to fail again. (It passed.) The result of the stress tests should be comforting to investors, who generally have been concerned about the global financial ramifications of Brexit.
Based on Wednesday’s results, Deutsche Bank said that it will strengthen its capital planning process, though the German bank has two years until their newly consolidated U.S. outpost—which is quite a bit larger than the portion of the company that was recently subjected to a stress test—comes under the Fed’s scrutiny. For Santander, this is the latest in a series of setbacks for the bank’s U.S. operations. Failing the test means that neither banks will be able to increase dividends or buybacks for their shareholders.
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