Sovereign Wealth Funds Should Keep an Eye On Fed Stress Tests

March 13, 2015 by Loch Adamson

SWC View: SWFs Should Keep an Eye on Stress Tests
U.S. Banks Pass Stress Tests — By the Skin of Their Teeth
Fed Stress Tests Reveal Potential Risks for SWFs
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Federal Reserve Governor Dan Tarullo (Credit: Bretton Woods Committee/Paul Morigi)

The Federal Reserve published the final results of its annual stress tests this week. Sovereign wealth funds would be well advised to pay close attention.

The U.S. Federal Reserve this week finished publishing the results of its annual Comprehensive Capital Analysis and Review. These detailed examinations of U.S. banks’ balance sheets and business practices — commonly known as stress tests — aim to determine how the financial institutions would fare in the event of another recession. Sovereign wealth funds can breathe a sigh of relief — perhaps.

The good news is that all of the big U.S. banks passed. The bad news? Some of them did so by the skin of their teeth.

Introduced by the U.S. government in 2009 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the stress tests are designed to find out whether a bank would have enough money to continue lending in what Federal Reserve calls "a severely adverse scenario," a hypothetically deep recession that includes housing prices plunging 25 percent, stocks nearly 60 percent, and unemployment hitting 10 percent. The results are intended to provide an indication as to how resilient each institution would be if another financial-market crash occurred. They also help determine what kind of money banks can return to investors via dividends and stock buybacks.

"Our capital plan review helps ensure that the capital distribution plans of large banks will not compromise their ability to continue lending to businesses and households even during a period of serious financial stress," Federal Reserve Governor Daniel Tarullo said in a statement on Wednesday. "It also provides a structured assessment of their risk management capacities."

Capital Returns

Although all of the banks proved sufficiently strong under the scenarios considered — at least according to the regulator’s definition — some were stronger than others. The key metric in the tests was the projected minimum Tier 1 common capital ratio: the amount of liquid capital like common stock the bank holds as a bulwark against unexpected losses as a percentage of its overall risk-weighted assets.

None of the banks fell below the projected minimum 5 percent ratio under the Federal Reserve’s "severely adverse scenario", but several came close. And two U.S.-based subsidiaries of European banks — Deutsche Bank and Santander Group — failed follow-up "qualitative" tests that are part of the exercise, and which judge capital planning processes and risk modelling. Critically for investors, the Federal Reserve’s stress test regimen determines whether a bank’s plans to return money to shareholders through dividends or share buybacks endanger its capital base and should be allowed.

Of the institutions tested, most of those with a major focus on the business of custody came out on top, with their projected minimum Tier 1 common ratios in the event of a severe recession beating the average of 8.3 percent for the 31 institutions tested. These included Bank of New York Mellon Corp. with a minimum 12.6 percent Tier 1 common ratio after the projected deluge, Northern Trust Corp. with a projected 12.3 percent ratio, State Street Corp. with 12 percent, and Citigroup with 8.2 percent.

Others fell below the average, including Wells Fargo & Co. with a projected minimum 7.6 percent Tier 1 common ratio, Bank of America Corp. with 7.1 percent, and JPMorgan Chase & Co. with 6.5 percent. And some of the bigger banks, including Bank of America., Goldman Sachs Group, JP Morgan and Morgan Stanley, were forced to take a so-called mulligan: that is, revise their initial plans to pay dividends or repurchase shares after they realized they were set to fail the second part of the part of the test involving capital returns.

Morgan Stanley and Goldman Sachs, with projected minimum Tier 1 common ratios of 6.2 percent and 6.7 percent, respectively, have significant trading businesses. They were ranked second and third lowest, just above Zions Bancorporation, whose ratio was 5.1 percent.

Asset Safety

The stress tests are of particular importance to sovereign wealth funds. First, state-owned investors are major shareholders in some of the banks being tested. China Investment Corp., for instance, bought a 10 percent stake in Morgan Stanley for $5.5 billion in 2007, and several funds, including the Abu Dhabi Investment Authority, Singapore’s GIC and the Kuwait Investment Authority, took shares in Citigroup when they stepped in with a billion-dollar support package for the bank in 2008.

Often a bank’s shares will rise or fall depending on how it fares in the stress tests — Citigroup’s share price nose-dived after it failed the tests a year ago, and has already risen sharply after the Fed’s announcement that it had passed this time around. Citigroup CEO Michael Corbat was widely expected to resign if the bank failed its stress test this year. His predecessor, Vikram Pandit, left in 2012 after the bank failed its stress test earlier that year, although it is unclear whether the test was a factor.

Bank of America was given only conditional approval on Wednesday by the Federal Reserve to return capital capital to shareholder. The Federal Reserve found deficiencies in aspects of the banks loss and revenue modelling as well as internal controls. It has until September 30 of this year to fix them. Bank of America shares fell the next day.

Secondly, and perhaps more importantly, there is the question of asset safety — funds use many of the banks tested as their global custodians. Since the 2008-’09 financial crisis, state investors have made great strides in their so-called front-end risk management procedures — those dealing with issues like diversification and portfolio volatility. But some funds have not been rigorous in keeping track of the risks associated with the manner in which their assets are ultimately stored and held with banks at the custody level.

Lurking Hazards

One persistent misperception the Sovereign Wealth Center has encountered with state-owned investors is the notion that there’s little difference between the various custodians of the financial world. Because they believe that the big U.S. banks are of similar quality, many sovereign wealth funds spread their assets among a number of different ones, assuming that by diversifying their holdings among different custodians they are mitigating risk.

The results of the stress tests show that there are problems with this strategy. There are big differences, even among the big U.S. banks, and some have proven safer and more resilient than others. For instance, those that offer custody as a sideline while focusing on more profit-generating operations — such as trading, prime brokerage or investment banking — fell closer to the 5 percent threshold than those for which custody is the main part of the business.

This isn’t just an issue for sovereign wealth funds, either. The failure of one of its global custodians may not necessarily pose an existential threat to a sovereign fund with a vast balance sheet and a multi-generational investment horizon — but for its smaller counterparties, with more immediate liquidity needs, the results could conceivably be catastrophic.

As funds become more closely linked with the wider financial markets, it behooves their risk managers to redouble their efforts to monitor the hazards lurking in their portfolios. And carefully reading the results of the Federal Reserve’s stress tests is a good place to start.

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