The Federal Reserve denied the capital plans for Citigroup Inc. and four other banking companies in its release of the second part of its yearly stress tests.
The nation's central bank approved the capital plans of 25 banks, but said it objected to those of Citigroup, HSBC North America, RBS Citizens Financial and Santander because of "qualitative concerns."
Can they handle the stress?
The stress test results are from the Comprehensive Capital Analysis and Review, or CCAR, test, which is the second of two stress tests results.
The first part of the stress test results,The Dodd-Frank Act stress test, or DFAST, the results of which were released last week, uses hypothetical situations to look at 30 banking companies with $50 billion or more in assets and measures how well those banks would be able to weather a major economic downturn.
The CCAR takes into account banks' capital action plans -- how they use their capital, such as for dividend payments, stock repurchases or planned acquisitions.
More simply put, the tests are meant to determine whether the companies have adequate controls and buffers in place so they wouldn't need a government bailout come troubling times.
"With each year, we have seen broad improvement in the industry's ability to assess its capital needs under stress and continuing improvements to the risk-measurement and risk-management practices that support good capital planning," Federal Reserve Gov. Daniel Tarullo said in a press release. "However, both the firms and supervisors have more work to do as we continue to raise expectations for the quality of risk management in the nation's largest banks."
Fed looking critically at qualitative data
The banks that passed their stress tests are likely to soon announce their capital plans to the public. The five that didn't pass can resubmit new plans within 90 days.
"The Fed stress tests are done, and now banks are stressed," says Mark T. Williams, a professor at Boston University and a former bank examiner at the Fed. "To be on the short list is not good."
For Citigroup, which has now failed the test for a second year (the first being in 2012), the Fed said that "while Citigroup has made considerable progress in improving its general risk-management and control practices over the past several years," there were a number of deficiencies, including at least somewhat of an inability to project revenues and losses under a stressful scenario.
"Taken in isolation, each of the deficiencies would not have been deemed critical enough to warrant an objection, but, when viewed together, they raise sufficient concerns" so that the Fed decided to flunk Citigroup on its stress test.
Williams says the Fed has been "branching out" and using more qualitative data in examining banks. He says the Fed is sending the message that, "even with strong capital, if you have weak risk-management and control practices, that's unsatisfactory."
Feeling the pressure
Williams noted that Citigroup's stock has fallen more than 5 percent in after-hours trading as a result of the stress test news. He said that the drop is probably an overreaction. Still, with a market capitalization of $152 billion, that drop "gives $7.5 billion reasons why they have to get off that list," Williams says of Citigroup.
Meanwhile, the Fed results also noted that Bank of America and Goldman Sachs each had to modify their plans to pass the test because they, like Zion, fell below at least one of the Fed's regulatory minimum thresholds.
Williams says it's important to remember that the stress tests are hypothetical, unusual scenarios, not something that's actually happening.
For a better understanding of the hypothetical scenarios the banks undergo in these stress tests, read Bankrate's blog post on the first of this year's stress test releases.
To get a sense of how secure your bank is now, check out Bankrate's Safe & Sound five-star bank ratings.
Follow me on Twitter for even more fascinating banking news: @allisonsross.