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Morgan Stanley & Goldman Got Help From Fed on Stress Tests … WSJ July 03, 2018 at 05:17AM

Morgan Stanley & Goldman Got Help From Fed on Stress Tests … WSJ

 

Morgan Stanley & Goldman Got Help From Fed on Stress Tests

Banks had option to freeze their payouts at recent levels, get a ‘conditional non-objection’ grade and avoid failing

By Liz Hoffman and Lalita Clozel

Federal Reserve officials told Goldman Sachs Group Inc. GS 1.22% andMorgan Stanley MS 0.68% that they were about to flunk a portion of the annual stress tests but offered
them a deal to avoid an outright fail and continue paying billions to shareholders.

In phone calls to executives of the Wall Street titans on June 21, regulators told them that to fully pass the test, they would have to cut almost in half the combined $16
billion they had hoped to pay out to shareholders, according to people familiar with conversations between the Fed and both banks.

But Fed officials gave the banks an unprecedented option: If they agreed to freeze their payouts at recent levels, they would get a “conditional non-objection” grade and avoid the black eye of failure. That meant
the banks could pay out a combined $13 billion, or about $5 billion more than what they would have given back to investors if they had decided to retake the test and get a passing grade.

It also will boost a profitability measure that helps determine how much Goldman Chief Executive Lloyd Blankfein and Morgan Stanley CEO James Gorman are paid.

The arrangement is the first of its kind in the eight years of the Fed’s annual tests, and one of the clearest signs to date of a significant shift in the regulatory environment for banks, which have been expecting
a gentler approach from Washington ever since the election of President Donald Trump.

“New refs, new rules,” consulting firm PricewaterhouseCoopers LLP wrote in a note.

This round of tests was the first graded by Trump appointee Randal Quarles, a former Wall Street lawyer and private-equity executive who last year became the Fed’s regulatory czar.

“This year’s stress test followed the same notification process as in past years—all firms were notified of the results and given the fixed option to reduce their capital payout plans with no negotiations,” a
Fed spokesman said.

Goldman and Morgan Stanley had failed the quantitative portion of the exercise, which tests​whether bank capital levels stay above regulatory requirements. A qualitative portion looks at more-subjective questions,
including the quality of a bank’s internal data or board of directors.​

The Fed’s willingness to compromise contrasts with its hard line of recent years. In 2014, for example, the regulator blindsided CitigroupInc. with a failing grade, leaving executives were scrambling to address
the Fed’s concerns. The same year, Utah-based Zions Bancorpalso failed on quantitative grounds. Like Goldman Sachs GS 1.22% and Morgan Stanley, the firm was able to keep its capital payouts level from the prior year, but was dinged with a formal failing grade.

The 2018 exercise was the harshest iteration of the stress tests so far, simulating a hypothetical scenario of 10% unemployment, crashing markets and soaring loan losses.

Fed officials said their leniency toward Goldman and Morgan Stanley was due in part to the impact of the 2017 tax law, which reduced the value of certain tax assets held by the banks and meant they entered the
crisis scenario with diminished capital reserves, affecting their results throughout the nine-quarter test period.

The decision came in a unanimous decision by the board, which includes Barack Obama appointee Lael Brainard.

The stress tests, arguably the most visible sign of the postcrisis crackdown on Wall Street, are being changed in ways that benefit the industry. The Fed exempted three firms with less than $100 billion of assets
from the test this year under the new banking law. Its treatment of Morgan Stanley and Goldman—as well as State StreetCorp. , which got a pass although it also failed to clear capital requirements under the stress scenario—showed the Fed taking a more flexible
approach to what had been a binary exercise.

“The Fed was very kind,” said Arthur Angulo, a managing director at Promontory Financial Group and a former Fed official. He added the Fed’s exercise of discretion on the quantitative portion of the test was “a
potential slippery slope.”

Agencies run by Trump appointees have moved to loosen rules in other ways. Regulators recently proposed easing the Volcker rule, which limits bank traders from making big bets, and are planning changes that could
make it easier for banks to meet lending requirements and reduce compliance penalties under the Community Reinvestment Act, which requires banks to lend in poor neighborhoods.

The interim director at the Consumer Financial Protection Bureau, Mick Mulvaney, has largely stopped initiating new investigations and wants the consumer-finance regulator to be less antagonistic to the businesses
it regulates. In May, Mr. Trump also signed a bipartisan law rolling back crisis-era rules for smaller and regional banks.

The deal with the Fed isn’t a total win for Goldman and Morgan Stanley, whose shares both fell by more than 1% on Friday. Investors want banks to raise their shareholder payouts every year as profits increase,
not keep them steady.

But the two banks fared better under the Fed’s offer than they would have if they had been forced to dial back their requests to the point where they passed the test.

If Goldman had been required to rejigger its plan until its capital ratios exceeded the Fed’s minimum, the bank would have been able to seek just over $1 billion in buybacks, instead of the $5 billion that was
approved, according to people familiar with the matter.

Other aspects of the Fed’s offer were unusually accommodating. The two banks could peg their shareholder payouts to one of two levels: either the amount they paid out over the past year, or an annualized average
of its payouts over the past two years.

Morgan Stanley had boosted its payout in 2017, so it chose the prior-year level. Goldman, which didn’t buy back any shares in the second quarter, gets a bigger number by using the two-year lookback. The difference
is worth about $570 million to Goldman shareholders.

Goldman can return $6.3 billion to shareholders, compared with $5.7 billion last year. Mr. Blankfein said in a statement that the bank is “positioned to return capital to our shareholders, while reinvesting in
our global client franchise for the long-term.”

Morgan Stanley was approved for the same $6.8 billion it paid out last year, which Mr. Gorman said “reflects the underlying strength and stability of our attractive mix of businesses.”

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