The largest financial institutions in the U.S. are collectively in a better position to withstand an extremely severe economic downturn than they were five years ago, according to the results of the Federal Reserve’s latest stress tests, with State Street being in the best position in terms of tier 1 common ratios.
As mandated by Dodd-Frank, the Fed tested a severely adverse scenario that includes a deep recession with a sharp rise in the unemployment rate, a drop in equity prices of nearly 50%, and a decline in house prices to levels last seen in 2001. In this scenario, the aggregate tier 1 common capital ratio for the 30 firms tested would fall from an actual 11.5% in the third quarter of 2013 to the minimum level of 7.6%, which is higher than their actual tier 1 common ratio of 5.5% in the beginning of 2009.
The results show that State Street’s tier 1 common capital ratio would remain at a robust 13.3%, which is better than the firm’s results from last year when it came in second place with 12.8%. BNY Mellon came in third this year behind Discover Financial Services; the custodian’s hypothetical ratio of 13.1% was down slightly from last year’s results of 13.2%. Northern Trust also passed the test easily at 11.7% (5% is a passing grade.). Only Zions Bancorporation failed the stress test, coming in at 3.6%.
Other custodians, who are less custody-specific than State Street, BNY Mellon and Northern Trust, passed the test but with less room to spare. For example, U.S. Bancorp came in at 8.2%, Citi at 7.2%, HSBC North America at 6.6%, J.P. Morgan at 6.3% and Bank of America at 5.9%. The differences between these institutions and the custody-focused banks can largely be explained by larger losses from loans, rather than just trading and counterparty default losses. For example, the Fed predicts Citi would see credit card losses of $24.8 billion, whereas State Street would have none.
This year’s tests expanded the list of institutions from 18 to 30 by including 12 more firms with assets greater than $50 billion. The Fed also used independent projections of balance sheet and risk-weighted asset growth rather than depending on the firms’ calculation for these categories as was done in prior years. The tests also included estimates of losses from counterparty defaults for eight firms with substantial trading or custodial operations.
The Fed also conducted an adverse scenario, which features a more moderate recession than that seen in the severely adverse scenario, but includes a steep rise in long-term interest rates. In the severely adverse scenario, the aggregate tier 1 common capital ratio would fall from an actual 11.5% in the third quarter of 2013 to the minimum level of 9.7%. The individual results fall along similar lines, with State Street and BNY Mellon still topping the list of custodians at 13.9% and 13.6% respectively, though Discover does move up to tie for first with State Street.
In addition to the Fed’s tests, Dodd-Frank also requires the firms to conduct their own company-run tests, which may have different results than the Fed’s tests.
This article has been updated to account for the Fed’s adjusted results. The central bank said it made adjustments “to address inconsistencies in the treatment of the fourth quarter 2013 actual capital actions and assumptions about preferred and employee compensation-related issuance over the course of the planning horizon.”
Custodians Fare Best in Fed's Latest Stress Tests
The largest financial institutions in the U.S. are collectively in a better position to withstand an extremely severe economic downturn than they were five years ago, according to the results of the Federal Reserve’s latest stress tests, with State Street being in the best position in terms of tier 1 common ratios.