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A Financial Buffer for the Markets

By By: Sean Reid Analyst I (Research)

Economic data released since the fourth quarter has pointed toward stronger signs for the US economy. Revisions to GDP, personal consumption and inflation for the fourth quarter 2011 all came in higher than previously estimated. The labor market seems to be showing signs of a sustained recovery, with the jobless rate falling to 8.3%, steady additions to payrolls since September last year and weekly jobless claims trending lower since the start of the year. With these signs of an improving economy, confidence levels have also strengthened and consumers have increased spending as evidenced by the surge in consumer credit over the last four months. On the backdrop of a slow yet steady recovery, the Federal Reserve released on Tuesday 13 March 2012, results of its latest stress tests on the financial sector. The results have proven to be positive with the majority of banks passing the grade. The initial market response to this news has been favorable, however, one may ask; "What does this necessarily translate into?"

During the financial crisis in 2008 into 2009, many US banks faced shortages in capital and sought a bailout from the Federal government through its Trouble Asset Relief Programme. To further tighten regulation within the sector, new legislation was passed (Dodd-Frank Act) and adjustments were made to existing regulations (in case of Basel III), both resulting in more stringent control of the sector. One measure that was of particular importance is the stress test. Stress testing is a measure of risk assessment, whereby a scenario analysis is done to test a variable under extreme circumstances. The 'stressed' variable is then measured against a benchmark to determine success or failure.

In terms of the most recent stress test conducted by the Federal Reserve, the benchmark used was the capital ratio. A total of 19 financial groups were assessed and the capital ratio stressed under the following macroeconomic scenario: 1) a more severe decline in real GDP than 2008/2009 2) an increase in the unemployment rate to 13% 3) a 50% decline in equity prices and 4) a 20% decline in house prices. The results of the stress test were measured against the Tier 1 risk based capital ratio of 6.0% (according to Basel III). The results revealed that of the 19 financial groups assessed, 4 failed (Table 1)

Apart from the macroeconomic scenario, the banks were assessed on potential losses on loan and securities holdings. An important facet of most banks is their trading positions. Thus, losses on both trading and counterparty positions were also factored into the stress test analysis. Based on the results it is estimated that such a scenario would generate US$534 billion in losses over the next nine quarters (including US$341 billion in loan losses and US$116 million in trading losses), which would more than offset the projected US$294 billion in revenues over the same period. Furthermore, it is estimated that net losses would lower the Tier 1 common capital ratio of the combined 19 banks under review from 10.1% to 6.3%. Nevertheless, 6.3% would still be above the regulatory minimum of 6.0% and the low of 5.5% hit in the aftermath of the collapse of Lehman Brothers in 2008.

The news announced by the Fed came as a relief to most in the market, adding a buffer to the positive economic news on the economy. Despite the success of major investment banks in the test (namely Bank of America, Goldman Sachs, JP Morgan Chase, Morgan Stanley and Wells Fargo), a "big name" was among the list of failures - Citigroup Inc. A passing grade on this last round of stress tests meant that banks got the all clear to increase dividends and engage in share repurchase programmes - both of which were outlined by these major banks. With Citi's failure, this proved to be a significant blow as it had planned to return capital to its shareholders this year. Despite the poor result, the company announced that it would propose a new plan to the Fed, and was optimistic that approval will be given for some form of share distribution to shareholders within the year.

The stress test results provided further impetus to the equity markets which saw the S&P 500 index rally 1.8% on 13 March 2012, which represented the best one day advance since November 2011. As at 15 March, year to date return on the index was 11.53% (see Chart 1) and saw the index rally above 1,400 for the first time since 2008. This compares to a 1.91% return for the same period last year. In terms of the S&P 500 Financial Index (Chart 1), the index year to date rose 20.61%, with the index being the largest contributor to the 1.8% surge on 13 March. The major banks all saw movements in their respective share prices and even some of the smaller financial companies saw increased trading activity. In anticipation of the results, during trading on the day that the report was released, Citi experienced a surge in its share price. The results were announced after trading hours and the price fell early the next trading day as markets absorbed the disappointing news (see Chart 2).

Despite the favorable news about the banking sector, some argue the rigidity of the stress tests and indication that it may give. The test, as mentioned earlier, signals the green light for these investment companies to increase dividends and share repurchases. The argument here is whether these banks would have sufficient capital to survive the next economic crisis.

With recent strong economic data spewing from the economy, positive news from the banking system will further add confidence to the markets. Already the equity markets have rallied and the financial sector is showing promise for the rest of the year. However, there still remain risks in the financial markets. Growth in Europe still remains a concern and its debt issues, though tempered somewhat from the Greek restructuring, are not settled. As the end of the first quarter approaches, the signs point to increased optimism in the markets, however, one should still be mindful of the potential downside risks that still remain.

All information contained in this article has been obtained from sources that First Citizens Investment Services believes to be accurate and reliable. All opinions and estimates constitute the Author's judgment as of the date of the article; however neither its accuracy and completeness nor the opinions based thereon are guaranteed. As such, no warranty, express or implied, as to the accuracy, timeliness or completeness of this article is given or made by First Citizens Investment Services in any form whatsoever.

First Citizens Investment Services and/or its employees or directors may, where applicable, make markets and effect transactions, or have positions in securities or companies mentioned herein. Neither the information nor any opinion expressed shall be construed to be, or constitute an offer or a solicitation to buy or sell.

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