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Banks to show beefed up capital in key regulatory reviews

In line with past cycles, this year's stress test and capital analysis results are expected to reflect a continued build-up of capital at U.S. banking institutions.

Results for the Dodd-Frank Act Stress Tests, or DFAST, are due June 22 and determinations from the Comprehensive Capital Analysis and Review, or CCAR, are expected June 28. Both tests have been hallmark supervisory processes since the crisis, with CCAR designed to examine capital planning at the largest and most complex banks while DFAST tests banks' ability to withstand possible economic recessions.

Following the 2016 cycle, the industry saw an increase in capital among tested institutions. An Ernst & Young paper observed increasing post-stress capital levels, with a McKinsey & Company report noting that larger and more complex institutions would be "held to a higher standard" in future cycles.

The trend toward requiring more capital, in order to weather possible economic downturns, is expected to continue with the 2017 cycle, which incorporates an escalated severely adverse scenario assuming a peak unemployment rate of 10% and a larger decline in commercial real estate prices.

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Michael Alix, a former regulator with the New York Fed's stress test team, said he doesn't think the amount of stress in the revised scenario would cause any institution to fall below its post-stress capital requirements.

"What I expect to see is a lot of capital resilience and assurance," Alix, now a partner at PricewaterhouseCoopers, said in an interview.

For 13 large and noncomplex bank holding companies, the Fed will no longer object to any plans on a qualitative basis beginning with this cycle. But some filers may face some extra scrutiny on leverage, since 2017 marks the first cycle in which the supplementary leverage ratio will be included. Beginning with the projected first quarter of 2018, advanced approaches institutions will have to maintain post-stress ratios of at least 3%, presenting a challenge for banks trying to couple growing balance sheets with ample capital levels.

Capital itself remains a focus as the Fed ponders the use of a risk-sensitive and firm-specific "stress capital buffer" in its CCAR examination, which could further expand capital requirements. Sullivan & Cromwell LLP Senior Chairman H. Rodgin Cohen said in an interview that he doesn't expect the buffer, which remains a proposal, to affect the 2017 cycle results.

"I think there is a natural concern that buffers are an add-on, not a subtraction, so I don't think you'll see a rush to add this until [the stress capital buffer], if ever, were a requirement," Cohen said.

The industry is also watching modifications to the cycle's pre-provision net revenue, or PPNR, calculations, which are banks' projections for post-crisis revenue levels. The Fed is gradually phasing in portions of its PPNR changes over a two-year period as part of an effort to evaluate performance at an individual firm level. Alix said the Fed's intention to transition these changes reflects the magnitude of the new calculations.

"That's really the wild card. If that was big enough, and frankly I doubt it is, but if it was big enough it could really surprise institutions and cause the stress effect to be greater than they expected," Alix said.

The industry will continue to watch payout ratios as well. Some companies could push the envelope and ask for permission to dish out higher payouts, as a result of the qualitative exemption. Banks might also ask for a higher payout because of a smaller cap on the amount of "de minimis" payout that they can distribute beyond the approved distributions in a capital plan. The cap used to be 1% of tier 1 capital but has been lowered to 0.25%, as part of an effort to discourage banks from distributions outside of what has been requested within the capital plan.

Cohen said banks are eager to get the regulatory green light for capital distributions, since dividends have become cheaper than stock repurchases following the postelection stock rally.

"There's just no way the organic growth can match the capital retained unless there are increases in payouts," Cohen said. "I doubt you'll see some gigantic change but I think the trend is likely to be upwards."