In the first stage of the test, leverage ratios at Goldman Sachs Group Inc. and Morgan Stanley were projected to drop close to the minimum allowed in a stressed scenario, sounding alarm bells about their ability to increase payouts to shareholders.

That test examined hypothetical losses with dividends continuing as before. The second phase looks at requests for future stock buybacks and higher dividends. Both firms quickly issued statements after last week’s result to warn against reading too much into it, arguing their capacity to distribute capital may be greater than what the numbers suggested.

Still, analysts have grown more skeptical the firms can increase their payouts -- or in Goldman’s case, that it can even maintain last year’s level.

“We don’t get to see all the details of how the Fed gets to its numbers, but it’s still hard to fathom how they can meet pre-test expectations,” said Brian Kleinhanzl at Keefe, Bruyette & Woods. “The math just doesn’t work.”

The pair may have to lower their proposed payouts to pass, Kleinhanzl said. Goldman already took that so-called mulligan twice since 2013, when the option was introduced. Morgan Stanley has used it once. Others saw the statements as lobbying the Fed for leniency, which could work in the bank-friendly regulatory environment under President Donald Trump.

“In the past that basically fell on deaf ears,” said Gerard Cassidy, analyst at RBC Capital Markets. “The new guys might look at it a little differently.”

Eoin Treacy's view

The results of the Fed’s stress tests are pivotal to the ability of banks to increase their dividends. The narrative behind why banks were turning to outperformance last year was that interest rates were rising which would improve margins and the tax cuts would lead to greater loan growth which was good for business and that combined this would lead to bigger dividends.

Right now, the S&P500 Banks Index yields 2.15% and the KBW Regional Banks Index yields 2.06%. Meanwhile the wider S&P500 yields 1.94%. You do get a pickup in yield by investing in banks but it is rather paltry compared to what investors were hoping for.


Systemically important banks, globally, are underperforming as China’s slowdown, Europe’s travails and trade war rhetoric take a toll. The underperformance of Chinese and European banks is not news but the S&P500 Banks Index closed at a new reaction lows yesterday and was barely steady today. A clear upward dynamic will be required to signal a return to demand dominance.

From a broader perspective financial conditions are tightening. Bull markets thrive on liquidity and banks are liquidity providers. If banks are underperforming that is sending an important message about the global liquidity situation which is all the more relevant because the Federal Reserve is due to accelerate its bond run-off to $40 billion a month in the third quarter.