Will Europe's Mega-Banks Fail The Upcoming Fed Stress Test?

The upcoming stress test might not bring good results to several big European banks. Deutsche Bank AG (USA) DB and Banco Santander, S.A. (ADR) SAN count among the major European banks that are likely to fail the U.S. Federal Reserve stress test owing to the banks' inadequacies in measuring and predicting possible losses and risks, per a Wall Street Journal release citing people acquainted with the matter. Notably, foreign banks were added in the stress test rule in 2014.

The periodic tests evaluate the financial stability of the banks under hypothetical stressful situations. These banks come under the U.S. Fed's Comprehensive Capital Analysis and Review (CCAR), which is conducted in compliance with the stress test rules of the Dodd-Frank Act. Assessing the health of the financial institutions since 2009, stress tests have been one of the important measures to prevent any further financial crisis.

The Fed is expected to reveal partial results of the test on March 5. Full results will be revealed on March 11 and this may include capital restrictions. The performance of Deutsche Bank and Banco Santander in the upcoming stress test is likely to contradict their results in the stress test that was conducted by the European Central Bank (ECB) in Oct 2014. Both the German banking giant and the Madrid, Spain-based bank were able to clear the ECB stress test.

While this year marks the first time that Deutsche Bank will undergo the Fed's stress test, it is second year for Banco Santander. Notably, several banks including Banco Santander, Citigroup Inc. C, HSBC Holdings plc (HSBC) and The Royal Bank of Scotland Group plc RBS failed the 2014 stress test run on qualitative grounds. The Fed held the opinion that these banks have loopholes in their risk management practices under a stressful scenario.

What's Expected?

A likely failure of the stress test would result in the imposition of restrictions on the U.S. units of Deutsche Bank and Banco Santander from making any dividend payment to their European parent companies and other shareholders.

Following its stress test failure last year, Banco Santander was subject to a restriction of its dividend payment. Violating such instructions, the bank paid dividend in second quarter 2014. In Sep 2014, the Fed took enforcement action against the Spanish bank for the violation and the bank was forced to repay the U.S. unit to offset the capital outflow and currently remains barred from declaring additional dividends.

In the upcoming test, Deutsche Bank Trust Corp., which represents around 5 percent of the total assets of Deutsche Bank AG, is likely to exhibit a well capitalized position, though it may fail on qualitative grounds. Banco Santander is expected to fail on similar grounds.

Apart from assessing the adequate capital levels, qualitative check is of equal importance in the stress test as it examines banks' controls and procedures in risk management, technology, stress test management and how banks have taken appropriates measures in business practices following the crisis.

Currently, Deutsche Bank is in working with the Fed over mitigating its loopholes in several areas in regulatory reporting, risk control, monitoring and compliance systems.

Bottom Line

European companies with large U.S. operations have increasingly drawn the attention of regulators. The 2008 financial crisis forced the U.S. government to rescue several foreign companies. In order to prevent any such financial downturn, foreign banks are required to follow tougher rules.

Notably, last year the Fed adopted a rule directing foreign banks with $50 billion or more in assets in America to establish an intermediary holding company in the U.S. As per the new rules, the holding company will be required to meet the same capital, risk management and liquidity standards as the U.S. banks. The banks are required to set aside more capital as buffer in times of unexpected losses.

The regulators are contemplating proactive measures to ensure that the world's largest banks strengthen their capital and liquidity positions to better combat another financial meltdown.

With respect to the upcoming stress test results, while nothing can be concluded with certainty, we look forward to how much healthier the banks emerge this time.