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Stress Test Shows 29 of 30 Banks Meet or Top Capital Target

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The Federal Reserve’s annual stress tests found 29 of the 30 largest U.S. banks could withstand a deep recession and still pay dividends, fueling speculation about which firms will win approval next week to raise payouts.

Zions Bancorporation is the only lender that came in below one of the Fed’s main capital thresholds in results released today by the central bank that simulated a severe economic slump. All 30 firms, including Salt Lake City-based Zions, topped the minimum in a separate scenario of rising interest rates. The Fed said capital levels have improved since the 2008 financial crisis and the largest banks are better positioned to lend and meet their financial commitments.

“The average person who relies on the banking system should be happy,” said Dan Ryan, head of PricewaterhouseCoopers LLP’s global financial regulation practice, calling the financial system safe. “Next week will tell us whether banks and bank shareholders will be happy.”

The Fed runs an annual two-part stress test required under the Dodd-Frank Act to ensure banks have enough capital and cash to withstand shocks that may threaten their survival. The goal is to head off a recurrence of taxpayer-funded bailouts as in 2008, when government rescues averted the collapse of some of the world’s largest lenders. Firms that fail a second round of tests released next week may have to forgo stock buybacks and higher dividends.

Projected Losses

Total projected loan losses for all 30 banks differed widely between the two scenarios. Under the adverse scenario of rising rates, banks lose $267 billion on all loans, including credit cards, commercial real estate, and mortgages. Under the severely adverse conditions, loan losses total almost $100 billion more, or $366 billion.

Fed supervisors this year scrutinized risks from litigation, counterparty failure, and high-yield loans as they guide banks toward higher capital buffers against financial and economic shocks.

Banks can’t pass or fail the test released today, which doesn’t take into account management actions to preserve capital. In the second round of tests released March 26, regulators will judge whether those actions, such as dividend cuts, keep banks above the minimum Tier 1 common ratio of 5 percent over nine quarters in harsh economic scenarios.

Stocks Advance

Investors bid up bank stocks before today’s results were released after the official close of trading. The KBW Bank Index, which includes 24 of the largest lenders, rose 2.2 percent for its best showing since Nov. 8 and its highest close since September 2008. Zions led gainers with a 3.2 percent increase, JPMorgan Chase & Co. added 3.1 percent and Bank of New York Mellon Corp. advanced 3 percent. They were little changed in after-hours trading.

Fed officials have cautioned that even banks that exceeded all the thresholds in today’s test may still find their requests for higher payouts rejected next week if regulators find the quality of the planning is flawed. The scrutiny can extend to management, systems and even boards of directors.

The bar on capital for the largest banks will continue to rise for the next several years, a Fed official said on a conference call with reporters. The official cited international agreements among regulators and the central bank’s own increasing demands for better risk management.

Five Ratios

The test included five regulatory ratios, and among the six largest U.S. banks, Bank of America Corp. and Morgan Stanley’s levels slid closest to the regulatory minimum in the Fed’s worst-case scenario. The firms came within 1 percentage point of falling below the 4 percent minimum on the Tier 1 leverage ratio under the “severely adverse” version, with Charlotte, North Carolina-based Bank of America’s ratio at 4.6 percent and New York-based Morgan Stanley’s at 4.7 percent.

Plans for higher dividends and buybacks still could pass muster next week because analysts have predicted the two firms will ask the Fed for less than the full amount they would be mathematically entitled to pay.

Bank of America’s $2.13 trillion in average total assets shows it could return about $12.8 billion to investors without falling below the leverage threshold, according to data compiled by Bloomberg. The lender may have requested an average $7.2 billion payout over the next 12 months, according to four analysts surveyed by Bloomberg.

Quality Call

Morgan Stanley’s $830 billion of average total assets shows it can return about $5.81 billion before falling below the minimum. The lender may have asked to return $2.1 billion, according to the estimates.

Qualitative measures are more of a judgment call by the Fed, and in past years, bankers have found their case weakened when results from their own internal calculations differed widely from the Fed’s.

This year, Bank of America estimated in a statement that loan losses in a worst-case scenario would be about 45 percent less than what the Federal Reserve projected at $30.3 billion. Wells Fargo & Co., the largest home lender, said its hypothetical loss would be $26.8 billion, or about half the Fed’s result.

The Fed said that in a severely adverse scenario, the minimum Tier 1 common ratio of Zions, based in Salt Lake City, is 3.6 percent. That’s below the 5 percent threshold, one of the regulatory measures used in next week’s test.

Recession Scenario

Banks under this test face a deep recession, with U.S. gross domestic product collapsing at a 6.1 percent annual rate in the first quarter of 2014 and real disposable income falling at a 2.4 percent pace.

Zions has already notified the Fed it will resubmit its plan after determining that losses triggered by new banking regulations will be less than anticipated. James Abbott, a spokesman for Zions, didn’t respond to an e-mail and phone call seeking comment.

The ratio of Tier 1 common equity to assets weighted for risk at all bank holding companies has averaged about 13 percent over the past two years, four percentage points higher than the average prior to 2009, the Fed said last month. Regulators use the ratio, which compares a firm’s common equity capital to its risk-weighted assets, to measure a bank’s cushion against losses.

Capital Hoard

“Banks are still hoarding a lot of capital — in other words they’re generating quite a bit internally and they’re not paying it out,” R. Scott Siefers, a managing director at Sandler O’Neill & Partners LP in New York, said before the results were released. “Capital levels by and large are very, very strong.”

The jobless rate in the severely adverse scenario rises to 9.9 percent in the second quarter of 2014. House prices fall 25 percent, and stock prices fall nearly 50 percent. Under the adverse scenario, the U.S. economy slumps into a recession for slightly more than a year. Stock prices drop 36 percent by the middle of 2014, house prices decline about 10 percent, and commercial real estate prices fall about 20 percent.

The adverse scenario includes a jump in the 10-year Treasury yield to 5.8 percent in the fourth quarter of this year. The yield currently stands at 2.77 percent. Yields on five-year Treasuries jump to 4.6 percent in the same time period, compared with 1.70 percent now, and rates on BBB corporate bonds jump to 9.1 percent.

Jason Goldberg, a bank-stock analyst in New York for Barclays Plc, told clients in a note this week that dividends for large banks will continue to rise this year.

“We expect this to mark the fourth straight year the median bank’s dividend payout ratio increases,” Goldberg said in the note.