The 2008 economic meltdown demonstrated the interconnectedness of the global financial system. Triggered by the one-two punch of the U.S. mortgage-backed securities meltdown and the subsequent liquidity crisis, the beating taken by too-big-to-fail players shined a light on systemic risk in the banking industry. As a consequence of that and a long list of government-sponsored bailouts, the solvency and resiliency of large financial institutions came under scrutiny. (For more, see: The Risks of Mortgage-backed Securities.)

While banks are now more independently responsible for ensuring their balance sheets contain enough capital to absorb future credit dislocations, the Federal Reserve Bank (as well as other central banks) still needs its proof. And they’re getting it by mandating regular stress tests for all banking organizations with at least $10 billion in assets.

Annually sponsored by the Fed’s Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act Stress Testing (DFAST), stress tests are a reality for 19 of the biggest U.S. banks, including Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM), Citigroup Inc. (C), and Morgan Stanley (MS).

How They Work

Stress tests are essentially balance-sheet assessments that analyze a bank’s solvency by placing it under hypothetical unfavorable economic circumstances. Whether self-imposed by a bank’s internal risk management desk, or by governmental regulators, the goal is the same: to detect and eradicate weak spots. (For more, see: The Fed's Stress Test on Banks.)

Concentrating on liquidity, market and credit risks banks may face when their financial health is strained, stress tests benchmark against assumptions which the International Monetary Fund characterizes as "unlikely but plausible." For example, an actual recent stress test scenario simultaneously factored in a 21% drop in housing prices, a 50% decline in equity prices, a 5% drop in gross domestic product, and an unemployment rate of 13%. The test looks at a bank’s Tier 1 common capital ratio, which is the common equity component of capital-to-risk-weighted assets. Banks are required to maintain a Tier 1 ratio of at least 6%.

In the last round of stress tests, all of the major banks passed. But for some, it was a close call. JPMorgan Chase estimated a Tier 1 common ratio 6.5%, Bank of America estimated a ratio of 8.6%, while Citigroup led the group, with an estimated 10% Tier 1 common ratio. But while they’ve all cleared the capital hurdle, this has done little to inspire confidence in investors looking to gain exposure to the banking industry. And while there is generally no evidence to suggest that the Tier 1 metric alone materially helps valuate a bank's stock, interestingly, Citigroup repurchased $1.2 billion of its common equity — roughly the same amount of employee stock it issues annually, following the announcement of its last Tier 1 rating. (For more, see: Is Now the Time to Buy the Big U.S. Banks.)

Community Banking Oversight

Community banks are exempt from the kind of stress testing directed at larger organizations. Nonetheless, the Fed emphasizes that banking organizations of any size should have the ability to plan and prepare for the impact of any potential financial tumult.

The Office of the Comptroller of the Currency (OCC) issued a bulletin entitled, "Community Bank Stress Testing: Supervisory Guidance," aimed at national banks and federal savings associations with $10 billion or less in total assets. Specifically, the bulletin advises community banks to “identify and quantify risk in loan portfolios and help establish effective strategic and capital planning processes.” The OCC’s recommendations also offer guidance pertaining to interest rate risk management and commercial real estate concentrations. (For more, see: Financial Regulators: Who are They and What They Do.)

European banks have also gotten into the stress test game. Initially, oversight was by the European Banking Authority (EBA), which was created in the wake of the global financial crisis. But starting in November, the European Central Bank (ECB) is due to take over as single supervisor. The ECB has announced that between now and 2016, it plans to stress test some 124 banking groups across 22 countries, with collective assets north of €30 trillion ($40 trillion).

The Bottom Line

Banks must pass regulatory stress test minimums to prove that they can handle unlikely but plausible market dislocations. While this will help ensure that capital preservation levels are where they must be to fortify banks from future economic turbulence, given that the recent round of Tier 1 ratings were just a few percentage points above statutory requirements, this fiscal health measurement doesn’t automatically signal a buying opportunity for investors looking for financial services industry exposure. (For more, see: Banking Stress Tests: Would Yours Pass?)