Major American banks will have to undergo yet another round of stress tests early next year to prove their financial mettle for confronting another recession. The three stress test scenarios - baseline (based on expectations of private economists), adverse and severely adverse - were revealed by the Federal Reserve on Thursday.
This will mark the fifth round of bank stress tests since 2009. The periodic tests monitor the financial stability of the 19 banks under hypothetical stressful situations. These banks are the part of the Fed's Comprehensive Capital Analysis and Review (CCAR), which is conducted in compliance with the stress test rules of the Dodd-Frank Act.
Further, the six largest banks - Citigroup Inc. C), Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM), The Goldman Sachs Group, Inc. (GS), Morgan Stanley (MS) and Wells Fargo & Company (WFC) - will also have to demonstrate their capability to endure significant global capital market shocks. The scenarios related to this will be revealed by the Fed by December 1.
Apart from these 19 banks, other 11 institutions - including Comerica Incorporated (CMA), Discover Financial Services (DFS), Northern Trust Corporation (NTRS), Zions Bancorp. (ZION) and Huntington Bancshares Incorporated (HBAN) - are a part of the Capital Plan Review (CapPR). The firms are required to conduct the 2013 stress test using just the baseline and the severely adverse scenarios to meet the CapPR requirements.
The environment of the last three rounds of stress tests and the upcoming one are unlike the first round of tests conducted by the Fed. The first round, which was conducted when the country was reeling under tremendous recessionary pressure, was meant to draw an estimate of how much the banks would lose if the economic downturn proved more devastating than expected. Since then, the test rounds are more like precautionary measures amid the economic recovery.
The Scenarios Ahead
Each of the three scenarios include 26 different variables (similar to the earlier stress test) such as employment and exchange rates, the anticipated changes in GDP, economic activity, prices and interest rates. Yet, a major difference this time is the inclusion of a substantial weakness in Asia owing to the slow growth of the Chinese economy.
Further, the Fed will test the banks' balance sheet under the impact of the slowdown across the economies along with severe recession in the U.S., Europe and Japan, leading to about 50% fall in equity prices. Other stressful circumstances include unemployment rate reaching 12.1%, home prices plummeting nearly 21% and the U.S. GDP falling by 6.1%.
The banks are required to file their capital plans by January 7, 2013 to undergo the new tests. They will have to adhere to this requirement even without any plan of enhancing shareholder value. The banks that intend to boost shareholder value (through dividend hikes and share repurchases) will also have to prove their capability to comply with the upcoming tougher Basel III banking regulations.
Moreover, dissimilar to earlier stress tests, banks are getting an opportunity to revise their capital plans, in case they fail to clear the stress test in the initial assessment. This will furnish the banks with an opportunity to amend their capital plans, thereby lowering the probability of a bank failing the stress test.
A Way to Recovery
Conducting the stress test is an efficient step undertaken by the Fed to evaluate the overall performance of the banking sector. These tests would help build up weak capital levels of banks, which are always a threat to the economy. In addition, this could ultimately translate into less involvement of the taxpayers' money for the bailout of troubled financial institutions.
While the government has been closely monitoring bigger banks and has also extended help through various simulative programs, many smaller banks are still struggling to stay afloat. Tumbling home prices, soaring loan defaults and still high unemployment rate continue to take their toll on small institutions. The government is required to implement policies to help all the industry participants contribute to the overall profitability.
However, if most of the major banks pass the stress test, it would definitely be a much needed spur to the pace of economic recovery.