Healthy Banking Index

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US banks have staged something of a recovery recently as the robust capital requirements put in place in the wake of the financial crisis, coupled with an upturn in the country’s economy, have served to strengthen the sector. While the country’s banking industry has been hit by several headwinds since the start of 2016 — including a plummeting oil price and volatile stock markets — lenders have weathered the storm well and are now on a much firmer footing. This is reflected by the fact that large banks including JPMorgan, Bank of America and Citigroup have recently announced dividend increases.

The relative health of US banks lies in stark contrast to their European counterparts, which have struggled on the revenue front and have cut dividends as they implement turnaround plans and cost-cutting measures. All of which has been played out against a background of stuttering European economic growth. Concerns about the European banking sector surfaced in dramatic fashion earlier in 2016 when Deutsche Bank AG was forced into issuing a rare statement of reassurance after holders of the bank’s CoCos fretted it would be unable to keep up coupon payments. Worries about European banks’ exposure to the energy sector amid the ongoing commodity rout have also heightened shareholder concern. Bank of America analysts said in a recent note that European banks face potential loan losses from energy firms amounting to 6% of pre-tax profits over three years.

The recent turmoil engulfing the European banking sector has even prompted some observers to draw parallels to the Lehman crisis. While this alarmist comparison, which came after a sell-off in bank stocks, overstates the danger, banks in Europe are clearly faring less well than those across the pond.

Meanwhile, fears over the investment banking sector as a whole were recently fanned when JPMorgan analysts cut their earnings estimate for global investment banks in 2016 by 20% due to a slowdown in deals and a challenging macro climate.

Nevertheless, the US continues to dominate when it comes to investment banking. According to a recent analysis by the Financial Times, the top five investment banks in Europe generate less than half the revenue of the top five US lenders. US banks are perceived to be more nimble operators and better able to adapt their business models to changing regulatory and economic fundamentals.

The differing outlook for the banking sectors in the US and Europe is mirrored in the divergent monetary policies pursued by their central banks. While the Fed increased rates in December 2015 and signaled its intention to implement further increases in 2016, the ECB has adopted a negative interest rate policy. A prevailing low interest rate environment spells bad news for banks’ net interest margins.

The gulf between US and European banks was thrown into sharp focus by the results of the Fed’s 2015 stress tests, or the Comprehensive Capital Analysis and Review (CCAR), which saw Santander Holdings USA and Deutsche Bank Trust Corporation (included as foreign banks operating in the US) emerge as the only institutions to fail the qualitative assessment. The fact the failure came after the two lenders passed their own ECB stress tests in late 2014 gives added weight to the argument US banks have had to operate in a more demanding and stringent regulatory environment which has ultimately benefited the sector.

This stricter regulatory environment has its roots in the financial crisis of 2007-2008. The causes of the crisis are complex and interconnected. The finger of blame has been variously pointed at regulators, credit rating agencies, financial institutions and Government housing policy. But banks, by lending out huge sums of money to people with poor credit, played a part in triggering the subprime mortgage crisis which sent large shockwaves through the housing market, the financial sector and the wider economy in a set of events which ultimately culminated in the Great Recession.

Bank stress tests were put in place after the financial crisis to address the fact that banks were overleveraged and overexposed to risky assets. A requirement of the Dodd-Frank Act, the tests which measure whether banks have enough capital to withstand the impact of a hypothetical economic shock and a series of adverse developments. The stress tests — conducted both internally by banks and by supervisory authorities such as the Federal Reserve — aim to discover weaknesses in the banking system at an early stage so that action can be taken to prevent another crisis.

While banks with over $10 billion in consolidated assets are required to evaluate and report their capital positions under the Dodd-Frank Act Stress Test (DFAST), larger bank holding companies with consolidated assets over $50 billion are required to submit capital plans to the Federal Reserve under CCAR.

CCAR uses qualitative and quantitative criteria to measure a bank’s “capital adequacy, capital adequacy process, and its planned capital distributions such as dividend payments and common stock repurchases.” The qualitative assessment “focuses on the internal practices a [bank] uses to determine the amount and composition of capital it needs to continue to function throughout a period of severe stress.” The quantitative assessment measures the bank’s ability to maintain capital requirements “under three hypothetical macroeconomic and financial market scenarios developed by the Federal Reserve: the baseline, adverse, and severely adverse supervisory stress scenarios.” These scenarios are designed to be exhaustive: they include, among other things, commodity price shocks, exchange rate fluctuations and bond default rates.

CCAR 2015 evaluated banks with total consolidated assets of $50 billion or more — those institutions the Fed considers the “largest and most complex financial institutions”. None of the 31 tested banks failed the CCAR quantitative test in 2015. But three banks came up short in the qualitative assessment. The Fed objected to the capital plans of Deutsche Bank Trust Corporation and Santander Holdings USA on qualitative concerns. The banks were therefore not allowed to “make any capital distribution unless the Federal Reserve indicates in writing that it does not object to the distribution”. Bank of America Corporation received a conditional non-objection and had to resubmit its capital plan by September 30, 2015. The bank was allowed to continue making capital distributions as long as it improved deficiencies, such as loss and revenue modeling practices and internal controls.

The Fed has toughened up the 2016 stress tests by assuming a more adverse economic scenario and factoring in the possibility of negative interest rates in the US in a nod to the action taken by several central banks across the world. The 2016 tests include a severely adverse hypothetical scenario whereby unemployment levels hit 10%, three-month Treasury bill rates fall to negative 0.5% and the country is hit by a severe global recession. Banks had to submit their capital plans and stress test results to the Fed by April 5. Stress test results will be announced by the Fed before June 30.

Meanwhile, earlier in April the Fed and the Federal Deposit Insurance Corporation said JPMorgan, Wells Fargo, Bank of America,  State Street Corp and Bank of New York Mellon failed their “living wills” — or plans for a bankruptcy not relying on taxpayer money. The banks are now required to address serious “deficiencies” in their plans by October.

CoreData’s banking index takes the results of the 2015 CCAR one step further by incorporating the capital ratios into an index measuring capital health in comparison with the financial performance of the bank or, where applicable, the parent company.

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