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
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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 -
Bank of America Corp.
JPMorgan Chase & Co.
The Goldman Sachs Group, Inc.
Wells Fargo & Company
) - 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
Discover Financial Services
Northern Trust Corporation
Huntington Bancshares Incorporated
) - 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
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
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
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
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