Less than 24 hours after cruising through the latest Dodd-Frank Act Stress Test, U.S. bank stocks were tumbling following the United Kingdom's vote to leave the European Union.
The unexpected move, known as Brexit, is another reminder of the unpredictability of markets and the impossibility for stress tests to envision every scenario. Skeptics argue the development shows DFAST's vulnerability."The bank no longer looks like what it did when it did its stress test," said Mayra Rodriguez Valladares, managing principal for bank consulting firm MRV Associates. "If you try to use the results from stress tests you did back in April, how valid are they now that the British pound is down nearly 10%?"
At the other end of the spectrum, stress-test enthusiasts say such shocks validate the exercise. With sophisticated models in place, banks can react to Brexit and stress their portfolios in real time by re-running the models with different inputs, said Ed Robertson, co-head of the financial institutions group for Situs.
"Banks and regulators can adjust to the results of Brexit, enter that into a model and get a result in hours or a week," he said in an email. "Before, there was no real way to stress test for this."
As for the actual stress-test results, all 33 banks passed with relative ease. Huntington Bancshares Inc. arguably came closest to breaching the Federal Reserve's minimums, with a Tier 1 common equity ratio of 5.0%, compared to a minimum of 4.5%. And Morgan Stanley and BMO Financial Corp. were close to the Tier 1 leverage ratio limit, both at 4.9%, compared to the required minimum of 4.0%.
While the Brexit vote appeared to take markets by surprise considering polling suggested a narrow victory for the Remain camp, there is scant worry that the vote will trigger a widespread recession. And since the stress tests envision a severe crisis, including 10% unemployment and a 50% crash in the stock market, banks appear well-positioned to handle any Brexit-related shocks.
"The U.S. banks subject to stress tests can withstand a heckuva lot of loss, and I don't think there is anyone looking at Brexit and saying that it will result in an immediate counterparty threat that is going to have spillover to broader markets," said Adam Gilbert, global regulatory leader of the financial services practice for PricewaterhouseCoopers.
Gilbert said banks do face a temporary headwind as the Brexit vote saps any momentum in stock prices the sector might have enjoyed from the June 23 stress-test results.
Analysts reacted positively to the stress-test results even if the markets were distracted. Compass Point Research & Trading LLC analysts said the Brexit vote "overshadowed" the positive stress-test results. The analysts said there was more variability in this year's exercise but noted that all banks were still comfortably able to absorb higher provisioning.Continue Reading the Full Analysis