Federal Reserve Governor Dan Tarullo (Credit: Bretton Woods
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
Introduced by the U.S. government in 2009 as part
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
"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."
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
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
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
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.
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.
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
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