My Cart
Capital Adequacy is a financial standard which has been developed by financial regulators to ensure banks can absorb a reasonable level of losses before becoming insolvent. This is usually expressed as a ratio of capital to risk weighted assets. Assets are adjusted based on their inherent risk. For example, loans that are secured by a letter of credit would be weighted riskier than a mortgage loan that is secured with collateral.
Two types of capital are measured—tier one capital ratio, which is the minimum amount of capital needed to absorb losses without a bank being required to stop trading, and tier two capital, which can absorb losses if the bank is dissolved. Tier 1 capital includes capital, reserves, equity investments, intangible assets. Tier 2 capital includes undisclosed reserves, loss reserves, hybrid debt instruments and subordinated debts.
Comprehensive Capital Analysis and Review (CCAR)
In November 2011, the Federal Reserve adopted the capital plan rule, which requires bank holding companies with assets of $50 billion or more to submit annual capital plans to the Federal Reserve for review. The Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR) measures the capital adequacy of large, U.S. bank holding companies and reviews the practices they use to manage risk (see below for qualitative and quantitative review descriptions).
Capital plans must include internal processes for assessing capital adequacy, distributions (stock issuance/dividends/repurchases); and any distributions planned over a nine-quarter planning horizon. Using Dodd Frank methodology, each bank must also report to the Federal Reserve the results of capital adequacy scenario analysis, evaluating the balance sheet under both baseline and stressed economic and financial conditions.
CCAR Qualitative Review
The Fed evaluates the bank’s risk management process—measuring, identifying and managing risk. Also, they look at corporate governance and internal controls—how the risk management group fits into the corporate structure. And, how valid the assumptions and analysis underlying the bank’s capital plan are.
CCAR Quantitative Assessment
The Fed evaluates each bank’s ability to make all capital actions detailed in its capital plan while maintaining post-stress capital ratios of greater than 5 percent Tier 1 common capital.
The CCAR quantitative assessment is based on the results of bank-run stress tests and post-stress capital ratios.
CCAR Results for 2014
On March 26, 2014, the Fed announced the results of the 30 banks which were reviewed. The results were 25 passes and five capital plan rejections. All but one of the five rejections was for qualitative reasons. (A qualitative rejection is viewed as a request for a revised submission rather than an outright failure.)
Citigroup was one of five firms to have its capital plan rejected for qualitative reasons, along with HSBC North America, RBS Citizens Financial, and Santander.
Zions Bancorp was rejected for quantitative reasons, as the bank failed to meet the Fed’s minimum Tier 1 capital ratio under a stressed scenario.
The largest bank, Citigroup, was rejected because it had not corrected some issues which had been brought up in previous reports. Specifically, the banks inability to project revenue and losses under a stress scenario and its inability to develop scenarios for its internal stress testing adequately.
The Fed stated in its report: “Taken in isolation each of the deficiencies would not have been deemed critical enough to warrant an objection, but, when viewed together, they raise sufficient concerns regarding the overall reliability of Citigroup’s capital planning process to warrant an objection to the capital plan and require a resubmission.”
Regarding HSBC and RBS Citizens, the Fed sighted “significant deficiencies” in their planning process, including “inadequate governance and weak internal controls around the process.”
For Santander, the Fed described the rejection as due to “widespread and significant deficiencies” across the firm’s capital plan.
Zions was rejected due to quantitative deficiencies, as a result of falling below the 5% Tier 1 capital minimum under a stressed scenario (4.4% under a severe economic scenario).
Implications to Rejected Banks
When the Fed has rejected bank capital plans in the past it has denied that bank any increase in its capital distributions from the prior year (but has not required that it reduce or stop distributions). However, the Fed could reduce or cease distributions if the Fed felt the weaknesses were severe. This year the Fed did not cease or require a reduction in capital distributions. However, the five rejected banks cannot go forward with their request for increased capital distributions and must resubmit revised capital plans to remedy their deficiencies.
Since the CCAR results, Zions, which failed the Tier 1 capital test, deferred giving Chief Executive Officer Harris Simmons a cash bonus until after the CCAR resubmission. The stock which opened at $30.75 on March 26 has been trading in the range of $28 to $31 since the announcement.
Citigroup failed CCAR for its inability to accurately project revenues and losses under stress scenarios. As a result, the Fed rejected Citigroup’s plan for a substantial increase in share repurchases as well as its $.05 dividend increase. Citi will have to go back to the 2013 $1.3 billion payout plan for 2014 unless it gets the qualitative deficiencies cleared up with the Fed. Citi has been trading down around 5% since the CCAR rejection.
