The Fed Weighs in on Stress Tests and Crude Oil

Risk, volatility and exposure to the energy sector
Domestic and international phenomena are evaluated, including exchange rates, inflation rates and other economic variables. The 3 conditions under which each of these variables tested includes: base line, adverse conditions and severely adverse conditions. What the stress tests have not taken into account is the impact of plunging crude oil prices and how that has severely impacted upon the solvency of banks. It should be borne in mind however that many of the major US banking institutions have low exposure to highly volatile US energy corporations. In fact, the numbers themselves are estimated at approximately 3% maximum exposure. Nonetheless, the plunging price of crude oil and the volatility that it brings to the markets has far-reaching implications for the broader economy. For example the communities that are supported by crude oil and other energy industries are affected. Things like real estate, mortgages, car loans and so forth all feel the pressure. It is therefore the smaller banks that have a higher exposure to energy loans.
Regional banks face mounting pressures in this regard, and this comes from none other than Moody's Investors Service. The 2016 stress test has been beefed up by the Fed. Owing to the presence of major global economic trauma, the Fed has decided that now is the time to evaluate whether major US banks will be able to sustain the current onslaught in the global economic arena. There are several new factors that have come into consideration, including increases in unemployment, negative interest rates in countries like Sweden, Japan and Norway, the threat of a British exit from the European Union (Brexit) , the re-entry of Iran into the global oil markets and how that will impact upon commodity prices like crude oil. Then of course there is the other looming threat of a major cyber breach on the US banking system, the US power grid or any other major government provided service. These are all aspects that can wreak havoc on the economy and place tremendous pressures on the US banking system which essentially props up the financial markets.

Major safeguards being implemented to protect US taxpayers from US banks
Now, banks will be especially cautious when they request permission from the Federal Reserve Bank to return capital via things like buybacks and dividends. Stress tests are essentially designed to prevent banks from collapsing or becoming a public burden when economic pressures become too much to bear. These are the main safeguards that the Fed has for protecting the economy from the failure of big banks. Unfortunately, 2016 has heralded a particularly inauspicious period for financial stocks, and all the major US banks, with the exception of a few have seen massive declines in their share prices. Investor sentiment has soured vis-a-vis the financial sector as a result of the complete loss of confidence in the ability of central banks to stabilise the global economy. This places additional pressures on to the Fed which then transfers these concerns onto banks in the form of more stringent requirements in stress tests. If anything, the turbulence in 2016 has caused increased concern about the ability of the US financial markets to sustain another crisis. The Fed wants to ensure that the US taxpayer does not pay for the failures of the US financial system.

Fed calling for maximum restraint on dividends and share buybacks
Just recently, the Governor of the Minneapolis Federal Reserve Bank intimated that the biggest banking corporations in America remain a threat of nuclear proportions to the American economy. There are increasing calls for higher levels of capital solvency so that there is a sufficient cushion to protect banks against economic downturns. In 2015 there were 3 major US banking corporations that did not pass the Federal Reserve Bank’s stress test requirements. These included Morgan Stanley, Goldman Sachs and JP Morgan Chase. The way that these banks became compliant was by working on their buyback and dividend plans. At the time, payout ratios were 119% for Goldman Sachs and 33% at Bank of America. The more that banks pay out to their investors, the less solvent they are, and the smaller the capital cushion that they can use to operate in time of a crisis. The Fed wants to cut that number down by restraining payout ratios as much as possible. In 2016, an expected 33 US banking corporations with a minimum of $50 billion in assets will be tested. In 2015 that number was 31 US banking corporations. The additional entrants include TD Bank's US unit and BancWest (owned by BNP Paribas). The publications for the data will be made in June 2016.

What new measures are being implemented in 2016?
A 2-part examination which began in 2011 will continue and it will determine whether US banks are capable of withstanding major global shocks the likes of which crippled Lehman Brothers in 2008. This year's test includes all the additional measures discussed above vis-a-vis unemployment, prolonged economic crises in Europe, Japan and emerging market economies, and the inclusion of short-term interest rates over a prolonged period of time. Operational risks will also be discussed and evaluated and the issue of class-action lawsuits also be taken into consideration as they impact upon the profitability and financial stability of major US banking institutions. For the most part, the stress tests focused on issues that are no longer part and parcel of the daily threat reality. This year, the threats are emanating from the commodities market, China weakness and emerging market economy failures. Currently there are 28 variables taken into consideration, a 29th may possibly be crude oil.

Please note that this column does not constitute financial advice.