During weak economic times, banks may be required to pass government mandated stress tests. If they fail, they could be required to take on more capital, thereby diluting existing shareholders, or worse, enter receivership with the FDIC, putting deposits in excess of insured amounts at risk and creating runs at anemic banks. Knowing what a bank stress test is and whether your bank is likely to pass can help the investor find good bank investments and the customer safer institutions.

What Is a Bank Stress Test?
The concept is relatively simple. The Federal Treasury estimates "adverse" economic scenarios and then judges whether the bank in question can weather the storm in case these assumptions are realized. Typically, an adverse scenario involves three input measures: real GDP, unemployment and housing price appreciation. (For an in-depth look, check out our Economic Indicators Tutorial.)

Toxic Assets
The mechanics of the stress tests are as follows. Bank regulators will look for toxic assets: assets they believe may be illiquid and therefore inflated in value. Generally, these are the bank's loans and investment securities. Most of the detail will be regarding the loans since this generally makes up the bulk of bank assets.

The regulators will segregate the loans based on loan type, then project losses based on the aforementioned economic inputs as they believe they relate to the current credit cycle. They will look at things like delinquency rates in the various categories and couple them with loss severity to come up with loss rates. These loss rates are then applied to the loan types to come up with projected equity depletion over the loss period, which is typically two years.

Credit Impairment
Next, the government will look for potential credit impairment in bank-held securities like collateralized debt obligations and uninsured mortgage-backed securities. Accordingly, they will discount the market value of these as well as coming up with a cumulative loss rate. Lastly, the regulators will consider the bank's counterparty risk and discount banks that have too much concentrated exposure. (To learn more, read The Risks Of Mortgage-Backed Securities.)

When the potential losses are accumulated and totaled under the adverse scenario, the regulators will offset these with the bank's ability to earn its way to strength. The fancy name for this is "pretax, pre-provision core earnings." Simply put, this is the bank's cash flow being generated from earning assets, or the remaining assets that are not being discounted.

Once the regulators have the potential loss and the potential income gains, they offset the two and tax them at the prevailing tax rates, since they would go through the income statement. Generally, a net loss will be the result since the banks are being adversely stressed in the scenario. This loss would then be applied against the current capital balances where it would be called pro forma capital, which basically means "as if."

At this point, the regulators will look at key banking measures like common equity levels as well as total capital levels. If the banks are above levels that the regulators have set for a bank to be considered "well capitalized," the bank passes the test. If not, the regulators will require the bank to raise more capital.

If it cannot, the FDIC may close the bank. If this happens, customers of the bank who have deposits over federally insured thresholds will have this portion of their money at risk, which could lead to a bank run. Similarly, bank investors would have their investments wiped out since all the remaining bank equity would be wiped out to first satisfy depositors and debtors. Ergo, this process is important to monitor. (For more, see Bank Failure: Will Your Assets Be Protected?)

Will Your Bank Pass?
If you hear that your bank will be undergoing a stress test, don't panic. Rather, logically try to determine if your bank will pass it. Some things you can consider are as follows.

First, if you are very financially astute you could try to read reports and conduct the mathematical exercise yourself. However, most of us are not comfortable doing that. Take heart, there are other ways.

A simpler way is to look at the types of loans that banks are making. For example, unsecured loans like credit cards are much riskier than commercial and industrial loans, which are well secured by business cash receipts and often real estate. Thus, high bank exposure in poorly secured loans could be a problem and is good to know up front.

Ratios Tell All
Examining financial ratios is another simple and good idea. The Texas ratio is often quoted as an indicator to bank failure. It is based off of nonperforming and delinquent loans as compared to equity and loan reserve levels. The higher this number, the greater your concern should be. (To learn more, see Texas Ratio Rounds Up Bank Failures.)

Another ratio to consider is the capital adequacy ratio. This ratio expresses a bank's risk-weighted credit exposure by measuring a bank's Tier 1 an Tier 2 capital against its risk-weighted assets.

Ranking Your Bank
Another thing that should be considered is how the bank in question compares to other banks. If its ratios are much better than the bank median, that's a good sign. If it is lower in the percentile rank, it's a warning sign. In economic boom times, the financial institutions may keep their capital levels low in order to return more money to shareholders in the form of capital. Simply put, this is leverage and works rather well for juicing returns in up markets.

However, in down markets this can come back to hurt the banks since their capital will see magnified erosion. While banks rarely fail, those with lower capital levels and poor underwriting will be hit first. Having a bank that is more in the middle of the pack on ratios than at the low end is a safer investment and financial institution, all else being equal.

The last thing investors and depositors can do is read research reports. These are typically written by savvy bank analysts who know the business very well. If a bank is weak and likely to feel duress under a stress test, the analysts will say so. If reports are relatively negative on the bank, then the customer or investor may want to look elsewhere for safer institutions. (For more, see Analyst Forecasts Spell Disaster For Some Stocks.)

The Bottom Line
Stress tests can be, for lack of a better word, stressful. However, knowing what a bank stress test is and whether your bank is likely to pass can help investors find good bank investments and customers put their money in safer institutions. The next time you hear that your bank is undergoing a stress test, don't panic; instead, be confident. Apply the principles discussed and you will be the better for it. (For more on the topics discussed, read Analyzing A Bank's Financial Statements.)

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