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Market Update

6 Takeaways From the Fed's Bank Review

The CCAR revealed concerns about several major banks' capital plans, including those at B of A and Citigroup, which likely will discourage shareholders in the near term.

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The Federal Reserve announced March 26 that it has approved the capital plans of 25 banks participating in the Comprehensive Capital Analysis and Review, but objected to five. Four objections ( Citigroup (C),  HSBC North America (HSBC),  RBS Citizens (RBS), and  Santander USA (SAN)) were over qualitative concerns, while one ( Zions Bancorporation (ZION)) was because it failed to meet the minimum post-stress test Tier 1 common ratio.  Bank of America's (BAC) and  Goldman Sachs Group's (GS) plans were approved after they submitted adjusted capital plans. We do not anticipate changing our fair value estimates or moat ratings for any of the banks, but we think there are several key takeaways from the CCAR results.

First, somewhat surprisingly, in our view, Citigroup's capital plan was rejected. Although Citigroup would maintain an adequate Tier 1 common ratio of at least 6.5% in a severely adverse case--according to the Federal Reserve's estimates--its plan was rejected on a qualitative basis. Regulators cited "considerable progress" at Citigroup but were apparently still concerned with the company's internal stress testing, particularly related to its international operations. Citigroup will be forced to resubmit its capital plan, and given that there were "a number of deficiencies" in planning practices, it appears that shareholders won't see major increases in dividends or repurchases until next year.

Second, Bank of America's initial failure to meet post-stress Tier 1 risk-based capital and Tier 1 leverage ratio requirements in a severely adverse scenario should be similarly discouraging to shareholders, in our view. Along with the firm's weak showing in the Dodd-Frank stress tests last week, the fact that Bank of America just skated by in the CCAR bodes poorly for 2014 capital returns.

Third, large U.S. subsidiaries of foreign banks were included for the stress tests for the first time in 2014 and had a difficult go of it. HSBC North America and RBS Citizens both passed the stress tests on a quantitative basis, with Tier 1 ratios of 6.6% and 8.1%, respectively, in the severely adverse scenarios, but their capital plans were rejected on a qualitative basis. The Federal Reserve found that both banks had deficiencies in estimating revenue and losses, and "inadequate governance and weak internal controls." We're not surprised by the finding for RBS--we've long thought that the U.S. subsidiary has been neglected while the parent focused on its massive turnaround, but we're more surprised by the finding for HSBC. HSBC was among the first large banks to identify problems in the U.S. mortgage market and has been cleaning itself up since 2007--the Federal Reserve's objection increases our questions about whether HSBC is simply too large and sprawling to manage effectively.

Fourth, Goldman Sachs received a nonobjection to its adjusted capital plan. Apparently, with its original capital plan, it would have had a minimum Tier 1 leverage ratio in 2015 of 3.9% compared with a regulatory minimum of 4%. Under the adjusted plan, its 2015 Tier 1 leverage ratio would be 4.2%. Overall, we remain satisfied with the company's capital ratios under the Federal Reserve's severely adverse scenario.

Fifth, the only bank that the Fed issued an objection to on a quantitative basis was Zions Bancorporation, as the severely adverse scenario of the test placed its ending Tier 1 common ratio at 3.5%, below the Fed's minimum 5% threshold. The magnitude with which Zions failed the test was a bit of a surprise, but the fact that Zions failed was less of a surprise given its recent disclosure that it held a significant amount of trust-preferred securities on which it took an impairment. Additionally, results indicated that the miss was due to preprovision net revenue evaporating and loan-loss provision expense and securities losses pushing net income deeply negative over the test horizon. The bank believes that part of the reason for the poor result was because the test was conducted on its security portfolio before it sold $630 million, or 28%, of its collateralized debt obligation portfolio in early 2014. Zions will be resubmitting its capital plan to account for this and other new information, but given the gap that it must close to reach the 5% Tier 1 ratio under a severely adverse scenario, it is unclear whether it will improve to a passing status.

Sixth, Santander Holdings USA, a wholly owned subsidiary of Spanish parent Santander, received an objection on qualitative grounds. The Fed cited deficiencies in its capital-planning processes that call into question the overall reliability of its capital-planning processes. This was a bit of a surprise to us because we hold the management of the parent in high regard. The bank will be required to resubmit its capital plan as a result. As a note, Santander Consumer USA, the banking operation in the U.S., was spun off by the parent in January and is 60% owned by the Spanish parent Santander.

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Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.