The Federal Reserve released the results from the second round of this year's stress tests on Wednesday, freeing up Morgan Stanley (NYSE:MS) and other large banks to increase their dividends and buy back more stock.

Morgan Stanley took little time to announce that it would do just that. The investment bank is raising its quarterly dividend to $0.25 per share, equating to a 25% increase, and it has added $5 billion to its share repurchase authority.

"For the fifth consecutive year we have increased our capital return to shareholders," said chairman and CEO James Gorman. He continued:

This underscores the strength of Morgan Stanley's capital position and the significant changes we have made to our business model and risk profile. We will continue to invest in our franchise and execute on our strategic priority of increasing capital returns subject to any changes to the CCAR process.

Metric

2017 CCAR*

2016 CCAR

Dividend per share

$0.25

$0.20

Stock buyback authority

$5 billion

$3.5 billion

*Comprehensive Capital Analysis and Review. Data source: Morgan Stanley.

The Dodd-Frank Act stress tests

Morgan Stanley's performance in the first round of this year's stress tests took a lot of the mystery out of today's news. The results from the first round, referred to as the Dodd-Frank Act stress test, or DFAST, were published last Thursday. They showed that Morgan Stanley comfortably exceeded the amount of capital it would need to survive an economic downturn akin to the financial crisis.

The controlling threshold in DFAST is a common equity tier 1 capital ratio, or CET1 ratio, of 4.5%. This is an entirely quantitative exercise. So long as a bank exceeds a CET1 ratio of 4.5% through the test's nine-quarter time horizon, it passes. If it doesn't, then it fails.

Going into this year's test, Morgan Stanley's CET1 ratio was 17.8%. This dropped to 9.4% at the low point in the exercise, though it remained well above the regulatory minimum.

Morgan Stanley's headquarters in New York City.

Morgan Stanley's headquarters in New York City. Image source: Morgan Stanley.

The Comprehensive Capital Analysis and Review

The central bank takes the DFAST process one step further in the Comprehensive Capital Analysis and Review, or CCAR. In this step, the Fed has the ability to veto big bank capital plans if the plans would change the outcome in the first round of the test -- that is, if the additional capital that would be paid out would cause a bank's CET1 ratio to fall below 4.5%.

As the Fed explains:

When considering a firm's capital plan, the Federal Reserve considers both quantitative and qualitative factors. Quantitative factors include a firm's projected capital ratios under a hypothetical scenario of severe economic and financial market stress. Qualitative factors include the strength of the firm's capital planning process, which incorporate the risk management, internal controls, and governance practices that support the process. The Federal Reserve may object to a capital plan based on quantitative or qualitative concerns. If the Federal Reserve objects to a capital plan, a firm may not make any capital distribution unless expressly authorized by the Federal Reserve.

Morgan Stanley struggled in last year's CCAR, with the Fed requiring it to resubmit its capital plan to address "certain weaknesses in its capital planning process." This year, there were no signs of similar troubles. After factoring in Morgan Stanley's planned capital actions, its minimum CET1 ratio fell to 7.9%.

Expectations that Morgan Stanley would pass this year's CCAR sent its shares up marginally on Wednesday, though they extended their gains in after-hours trading.

John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.