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Fed's Annual Stress Test Results: 28/31 Pass - Deutsche & Santander Fail, BofA To Re-Submit

After all 31 banks passed Dodd-Frank's "stress"-test with flying colors and awaited The Fed's CCAR blessing to spread the wealth to shareholders, we thought ironic that The Fed's Tarullo had previously commented that "we don't want banks to know the stress-test scenarios and tailor their portfolios to meet our goals," because that would never happen. The CCAR results are now out and 28 of 31 passed. Deutsche Bank, Santander failed for "qualitative" reasons (with significant and widespreasd deficiencies in risk management) and Bank of America will need to resubmit their proposal.

 

Financial Stocks had gone in hopeful...

 

Which looks a lot like last year... before stocks reverted lower.

 

As part of the Comprehensive Capital Analysis and Review, the Fed evaluates a bank's capital adequacy and planned distributions, such as dividend payments and common stock repurchases. If the Fed objects to a holding company's capital plan, the firm may not make any capital distribution unless the supervisor indicates in writing that it does not object to the distribution.

Last week, the Fed released the results of the Dodd-Frank stress tests, and all 31 banks were found to have enough capital to make loans if a severe economic downturn were to strike. The Fed tested each bank under severely adverse conditions, and each company's Tier 1 common capital ratio exceeded the regulator's five-percent minimum.

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This should be no surprise as we noted previously Deutsche and Santander would fail.

As USA Today reports,

Bank of America, the nation's second largest bank, received a conditional okay for its capital spending plan on Wednesday, but must resubmit its spending plan in September due to "deficiencies" in its revenue modeling and internal controls.

 

Bank of America's (BofA) internal flaws came to light on Wednesday when the Federal Reserve released phase two of its so-called stress test, which aims to spot capital weaknesses in the nation's top 31 banks.

 

Overall, only two of the 31 banks failed to pass the second phase of the test, which determines whether the nation's top banks are strong enough to spend their cash on things like dividends and stock buybacks.

 

The Fed flat out objected the capital spending plans of Deutsche Bank Trust Corporation and Santander Holdings USA, Inc. due what it said were "widespread and substantial weaknesses across their capital planning processes."

 

It's the second year in a row that Santander Holdings, a unit Santander Group of Spain, has flunked the second phase of the Fed's test.

 

The Fed said will give BofA until September 30th to remedy the deficiencies and resubmit its capital spending plan. If BofA does not properly address the weaknesses the Fed has identified by that time, the Fed could object to BofA's resubmitted capital plan and restrict BofA's capital distributions, it said on Wednesday.

BofA is not the first bank to receive a conditional okay as a result of the Fed's stress tests. In 2013, Goldman Sachs and JPMorgan also received conditional approval for their capital payouts.

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There are two big problems with Deutsche Bank failing the Fed's stress test as the WSJ just reported it would.

This is what the WSJ reported moments ago:

Large European banks including Deutsche Bank AG and Banco Santander SA are likely to fail the U.S. Federal Reserve’s stress test over shortcomings in how they measure and predict potential losses and risks, according to people familiar with the matter. Failing the stress tests would likely subject the U.S. units of Deutsche Bank and Banco Santander to restrictions on paying dividends to their European parent companies or other shareholders.

Why is this an issue?

Well, the first problem is that Deutsche Bank recently passed the ECB stress test with flying colors. Then again, since that was a "test" which not even in its worst-case scenario modeled for deflation (as a reminder, Europe just suffered its record worst deflation in history on par with the Great financial crisis), one can now roundly dismiss any and all current or future analytical, regulatory and executive tasks conducted by the ECB. We will ignore the fact that the world's biggest bond buying program is currently being undertaken by precisely said clueless central bank. We will also ignore the other fact, that the bank of the former FDIC-head Sheila Bair, Santander - a bank which is currently the biggest subprime auto loan lender - will also fail the stress test: to dwell too much on that particular irony would give us a headache.

The WSJ did provide a token explanation for this particular "oversight" by the ECB:

Deutsche Bank Trust Corp. is expected to be found adequately capitalized by the Fed but will likely receive a warning on qualitative shortcomings, according to people familiar with the matter.

 

Both Deutsche Bank and Santander passed European Central Bank stress tests in October. Those tests focused on whether the banks had enough capital to withstand a two-year recession but didn't assess such things as governance, risk management, and other more subjective factors like the Fed’s test.

Actually, the explanation that Deutsche Bank is lacking in its "risk management" department should be enough to give one a chill, especially when one considers the second big problem. Then again technically it not just a second problem: it is some 62.2 trillion problems, which is what the gross notional exposure of all derivatives on the Deutsche Bank balance sheet is pre-netting (and as Lehman showed us, netting only works in a perfect world in which there isn't one single counterparty failure: if there is, there is no netting and gross instantly becomes net, simple as that).

 

So a bank which has €54.7 trillion, or a little over $62 trillion at today's exchange rate, in derivatives - a number that is 20 times greater than the GDP of Germany -  just failed a central bank stress test due to lacking governance and risk management controls and, just maybe, has insufficient capital? What can possibly go wrong.

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