Fed puts European banks on notice to improve US controls

European banks operating in the United States face an expensive challenge to meet tough standards set by regulators after both Santander and Deutsche Bank flunked a health check and were told to improve systems and controls.

Spain's Santander failed the Federal Reserve's "stress test" for the second consecutive year and Deutsche Bank failed at the first time of asking due to weaknesses in their capital planning processes.

The setback could limit dividend payments the US arms can make to parent groups. Its main impact is likely to be to force banks to beef up internal controls and risk identification and management - potentially spending hundreds of millions of dollars to do so.

"This capital planning is not just for now, it's for the future. It's looking more at their sustainable business model and over time how they define the process and make it documented," said Sven Ludwig, senior vice-president of risk and analytics for EMEA at software and technology services firm SunGard.

The failures will also fire warning shots across other foreign banks which are expected to undergo the annual examination in coming years, including Credit Suisse, Barclays and UBS.

US regulators have toughened rules on overseas banks to make sure their American operations have enough capital to withstand a problem there. The stress tests also aim to ensure foreign banks are as well-run as domestic ones.

Both Deutsche and Santander were already having problems in their US businesses, although both were deemed to hold enough capital by the Fed. Deutsche Bank, which competes head-to-head on Wall Street with the likes of JP Morgan and Goldman Sachs, is investing $1 billion over four years to improve its US internal reporting and controls.

Last year the New York Fed found serious problems in its US operations, including shoddy financial reporting, weak technology and inadequate auditing and oversight, sources have said.

The bank has hired 500 staff to address weaknesses in US financial reporting, including Elizabeth Ford from Goldman Sachs as head of compliance in the Americas.

Santander is trying to clean up its US operations under one holding company, including centralising risk controls and systems, but that could take several years.

It inherited some problems from Sovereign, which came under its control in 2009 after a string of acquisitions.

New Santander boss Ana Botin has shaken up management there and appointed former JPMorgan executive Scott Powell as CEO of the US holding company two weeks ago.

Santander is spending about $170 million a year to address the issues and has hired about 500-600 people to deal with compliance and risk management in the past 18 months.

"This clearly means that Santander Holdings USA still has a lot of work to do and the progress achieved has been scarce," analysts at Kepler Cheuvreux said in a note to clients.

The US stress tests differ substantially from tests carried out by European regulators. The Fed assesses a bank's future earnings, strategy and dividend plans and whether systems can identify and prepare for risks - and will force lenders to change if it doesn't like the plans.