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HPSinsight.com March 12, 2012

Client Note STRESSING OVER STRESS TESTS

By Patrick Sims, (202) 822-1205, psims@hamiltonps.com

Capital is central to a bank-holding company's ability to absorb unexpected losses and continue to lend to creditworthy businesses and consumers.i US Federal Reserve In the coming days, the Federal Reserve will release the results of the annual Comprehensive Capital Analysis and Review (CCAR), better known as stress tests, for the largest bank-holding companies (BHCs) in the U.S. The regulation requires top-tier BHCs with total consolidated assets of $50 billion or more to submit capital plans based on adverse scenarios. Plans were required for submission on January 9, 2012. The Federal Reserve is expected to release results by March 15. Even prior to knowing the results of the tests, there are ways to assess the strength of banks and understand what has changed since the crisis. As outlined in the new Hamilton Financial Index (HFI), capital levels for U.S. financial institutions are at an all-time high, and the level of risky assets has diminished considerably since the crisis. While capitalization of the industry is very different than company-specific capitalization, and results will vary from one bank to another, we can look at a snapshot of where the industry currently stands. Stress Testing the HFI HPS Insight, the research division of Hamilton Place Strategies, conducted our own snapshot stress-test scenario through the recently released Hamilton Financial Index (The report was commissioned by the Partnership for a Sound Financial Future and can be read here). As an overview, the Hamilton Financial Index is measured by using two commonly accepted metrics: 1. The St. Louis Federal Reserve Financial Stress Index (STLFS), a well- established indicator of financial stress capturing 18 market indicators 2. Tier 1 Common Capital Ratio (Tier 1) for commercial banks measuring financial institutions ability to absorb unexpected losses in an adverse environment
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The trend of the HFI is outlined below, and the summary is that the index is now higher than it was pre-crisis, which indicates strength in our financial sector. In the spirit of stress-test week, we thought it would be interesting to stress test our own stress test. To do so, we looked at the hypothetical level of the HFI at its lowest point, the second quarter of 2008, while keeping Tier I constant at its current level. This shows how current capital levels act as a large buffer to financial stress. As of the fourth quarter of 2011, the industrys Tier 1 was at 12.56, an all-time high, and a 36 percent increase from its low-point in 2007. The results seen below are clear at the time of the crisis, the index would have had a value of .76, which is .30 points higher than what actually occurred. In past analysis, we identified the average level of safety and soundness to be around the index value of 1. The decline at todays levels would have been .24 points, or 24 percent below the historical norm, instead of the actual outcome of a decline of .54 points, or 54 percent away from normal. If capital levels at the time of the financial crisis were at current levels, the industry would have been much better prepared to withstand financial stress. Exhibit!1 !!

THE HAMILTON FINANCIAL INDEX SHOWS CURRENT CAPITAL LEVELS PROVIDE LARGER BUFFER FOR STRESS!
Hamilton Financial Index!
1.50! Actual Value! Hypothetical*!

1.25!

Index Value!

1.00!

0.75!

0.76!

0.50!

Given todays capital levels, the Hamilton 1.24! Financial Index would be 30 points higher during the nancial crisis of 1.15! late-2008.! ! The Tier 1 Common Capital Ratio was at 12.56 as of the fourth quarter of 2011, a 36 percent increase from its low-point in 2007.! !

0.46!

1994!

1995!

1996!

1997!

1998!

1999!

2000!

2001!

2002!

2003!

2004!

2005!

2006!

2007!

2008!

2009!

2010!

Source: HPS Insight, St. Louis Federal Reserve, SNL Financial! !

2011!

0.25!

* Assumes 12.56% Tier 1 Common Capital ratio for all time periods!

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Fed Stress Test Expectations Financial industry leaders, such as Jamie Dimon of JPMorgan Chase, believe the release of the stress-test scenarios will eliminate questions of safety. If banks can demonstrate that they have sufficient capital, even in the most catastrophic of scenarios, it will be further proof that the financial industry is both safe and sound. However, supervisors do have the authority to restrict capital distributions (dividends) and require institutions to take actions to improve its capital adequacy. As a result of CCAR 2011, regulators rejected proposed dividend increase by both Bank of America Corp. and Capital One Financial Corp. While the CCAR results may lead to some restriction considering the differences across companies due to disparities in capitalization, we expect the results will be overall favorable for the financial industry. Below is additional background on the stress scenarios and the thresholds expected of financial institutions. CCAR Stress Scenarios Outlined below are some of the stress-test scenarios as identified by the Federal Reserve: All [stress test] scenarios start in the fourth quarter of 2011 and extend through the fourth quarter of 2014. Decrease in GDP: An annualized decline in real U.S. GDP of 4.84 percent in the fourth quarter of 2011, 7.98 percent in the first quarter of 2012, 4.23 percent in the second quarter of 2012 and 3.51 percent in the third quarter of 2012 before leveling out and then increasing from there until the end of the scenario Increase in Unemployment: The unemployment rate peaks at 13.05 percent in the second quarter of 2013 Stock Market Crash: The Dow Jones Total Stock Market Index falls to 5,668.34 in the fourth quarter of 2012 Drop in Commercial Real Estate: A 23 percent decline by 2013 Housing Prices Plummet: Prices fall 20 percent by 2014 Global Economic Malaise: Domestic economic stress with fluctuations in the euro-area market, Japan, developing Asia (Hong Kong, Taiwan, China and India) and the United Kingdom throughout the testing time horizon An additional analysis will take place for six of the firms with the largest trading operations. This analysis will be based on global market shocks, based on price

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and rate movements that occurred in the second half of 2008, around the time of the Lehman Brothers failure. Facts and Figures Nineteen of the 31 firms took part in CCAR in 2011, and another 12 more were added for the 2012 scenario. While the industry has questioned the full extent of what will be released, the official CCAR manual states that at the completion of the exercise, the Federal Reserve will disclose its estimates of revenues and losses, as well as pro forma, post stress capital ratios The 31 companies are expected ...to maintain capital above each minimum regulatory ratio and above a 5 percent tier 1 common ratio under expected and stressful conditions, with stress testing carried out both by the firms and the Federal Reserve. As of the fourth quarter of 2011, the average Tier 1 Common Capital Ratio for the 31 financial institutions was 10.97, up 36.6 percent from the first quarter of 2009. The highest ratio among the group was 16.84, while the lowest was 6.86. (Exhibit 2)

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Tier 1 Common Ratio for 31 BHCs in Fed's Comprehensive Capital Analysis and Review (2012)
Company 2011Q4 Ally Financial Inc. 7.54 American Express Company (AXP) 12.31 Bank of America Corporation (BAC) 9.86 Bank of New York Mellon Corporation (BK) 13.43 BB&T Corporation (BBT) 9.74 Capital One Financial Corporation (COF) 9.67 Citigroup Inc. (C) 11.80 Fifth Third Bancorp (FITB) 9.35 Goldman Sachs Group, Inc. (GS) 12.07 JPMorgan Chase & Co. (JPM) 10.07 KeyCorp (KEY) 11.26 MetLife, Inc. (MET) 9.39 Morgan Stanley (MS) 13.01 PNC Financial Services Group, Inc. (PNC) 10.29 Regions Financial Corporation (RF) 8.51 State Street Corporation (STT) 16.84 SunTrust Banks, Inc. (STI) 9.28 U.S. Bancorp (USB) 8.55 Wells Fargo & Company (WFC) 9.36 BBVA USA Bancshares, Inc. 11.18 BMO Financial Corp. 9.93 Citizens Financial Group, Inc. 13.34 Comerica Incorporated (CMA) 10.37 Discover Financial Services (DFS) 13.03 HSBC North America Holdings Inc. 13.43 Huntington Bancshares Incorporated (HBAN) 10.00 M&T Bank Corporation (MTB) 6.86 Northern Trust Corporation (NTRS) 12.06 RBC USA Holdco Corporation 14.17 UnionBanCal Corporation 13.82 Zions Bancorporation (ZION) 9.57 Average 10.97 High 16.84 Low 6.86 As of March 5, 2012. List includes Bank Holding Companies with at least $50 billion in total assets. Data collected from regulatory filings. Source: SNL Financial Tier 1 Common Ratio 2011Q1 2010Q1 8.40 4.96 11.81 9.75 8.64 7.61 12.36 11.62 9.32 8.64 8.40 6.54 11.34 9.11 8.99 6.96 12.79 12.40 10.03 9.06 10.74 7.51 7.82 8.81 8.94 NA 10.31 7.86 7.92 7.13 17.46 15.93 9.05 7.70 8.18 7.08 8.78 6.96 11.71 9.32 12.12 10.14 13.01 11.38 10.35 9.56 12.45 11.24 12.55 11.34 9.75 6.55 6.79 5.90 12.99 12.83 14.86 NA 12.84 11.96 9.33 7.14 10.65 9.07 17.46 15.93 6.79 4.96 2009Q1 NA 11.44 4.47 10.05 6.99 7.66 2.16 4.50 8.47 6.88 5.62 9.19 6.19 5.01 NA 14.75 5.83 5.44 3.30 7.44 8.23 7.47 7.31 NA 6.46 5.67 5.99 10.13 NA 8.72 5.73 7.08 14.75 2.16

Patrick Sims is a senior analyst at Hamilton Place Strategies. Prior to joining HPS, Patrick acted as a lead research analyst in the financial institutions group at SNL Financial LLC and worked for the CFA Institute. He is a Finance and International Business graduate of James Madison University and studied EU Policy at the University of Salamanca in Spain.

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