Most U.S. banks pass Fed’s stress test, but Morgan Stanley faulted

All but one of the nation’s largest banks earned an unconditional passing grade from federal regulators on their annual stress tests, which measure their preparedness to weather a financial crisis.

The one U.S.-based institution that did not pass unconditionally was Morgan Stanley, a Wall Street bank that has been struggling to regain its footing after the financial crisis of 2008. Regulators raised concerns over the company’s internal controls and processes.

The Federal Reserve gave failing grades to the U.S. subsidiaries of two European banks, Deutsche Bank and Santander, which both failed in previous years.

The banking stress tests — which measure whether banks have enough capital and liquidity, management controls and other necessary safeguards to survive various worst-case situations — have been required of banks with more than $50 billion in assets since the passage of the DoddFrank act, which took effect in 2010.

The passing grades mean that all of the big banks — even Morgan Stanley — will be able to pay dividends and buy back stock from shareholders. The failing banks will not.

The results, announced by the Fed on Wednesday, are the second part of the annual stress tests, which compel each institution to run a simulation of how it would bear up under various catastrophic conditions, like an abrupt rise in interest rates or unemployment, or a big crash in equity markets. Last week, the Fed said that all the big banks would be able to make it through a recession and still maintain adequate financial buffers.

On Wednesday, a Fed official said that even with the concerns raised, the stress test results suggest that banks would be able to withstand an event like Britain’s exit from the European Union, which has rocked bank stocks over the last week.

This year’s results will no doubt be a welcome relief, in particular, to Bank of America and Citigroup, which have had difficulty passing the test unconditionally in past years.

The three banks that were called out by the Fed this week all had big enough financial buffers, the Fed said. But regulators criticized more qualitative aspects of the way the three banks operate internally.

At Morgan Stanley, the Fed said, the problems “include shortcomings in the firm’s scenario design practices, which do not adequately reflect risks and vulnerabilities specific to the firm, weaknesses in some aspects of the firm’s modeling practices, and weaknesses in governance and controls around both scenario design and modeling practices.”

Morgan Stanley will be able to return money to shareholders, as planned, but it will need to improve its internal processes by the end of the year. If the bank does not make those improvements, the Fed could halt the bank’s payouts.

The results are an unhappy hiccup for Morgan Stanley, which has been struggling to raise its profits to the level of its competitors’ and is in the middle of a significant costcutting campaign.