American banking giants, along with subsidiaries of certain
foreign banks will have to undergo another round of stress tests
early next year. Last week, the Federal Reserve revealed the
three stress test scenarios - baseline (based on expectations of
private economists), adverse and severely adverse. This will mark
the sixth round of bank stress tests since 2009.
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The Fed has added 12 more financial institutions this time to its
previous list of 18. These banks will have to prove their
financial capability of withstanding another recession and
enhance or maintain their capital plans.
The periodic tests evaluate the financial stability of the banks
under hypothetical stressful situations. These banks come under
the Fed's Comprehensive Capital Analysis and Review (CCAR), which
is conducted in compliance with the stress test rules of the
Dodd-Frank Act. Some of the newly added financial institutions
were previously part of the Capital Plan Review (CapPR).
Similar to prior tests, the six major banks, namely
Bank of America Corp.
JPMorgan Chase & Co.
The Goldman Sachs Group, Inc.
Wells Fargo & Company
), will have to demonstrate their capability to endure
significant global capital market shocks. The Fed will soon
reveal the scenarios related to this.
The Bank of New York Mellon Corporation
State Street Corporation
) will incorporate a counterparty default scenario. This will
replace the counterparty incremental default risk calculation of
the prior year's stress test.
The newly added banks include
Discover Financial Services
) and the subsidiaries of foreign banks such as BMO Financial, a
Bank of Montreal
) of Canada; BBVA Compass Bancshares, held by Spain's
Banco Bilbao Vizcaya Argentaria SA
) and Santander Holdings USA, which is held by Spain's
Banco Santander SA
The environment at the time of the last four rounds of stress
tests was quite different from that of the first round of tests
conducted by the Fed. The first round, conducted when the country
was under considerable recessionary pressure, was meant to draw
an estimate of how badly the banks would fare if the economic
downturn proved more devastating than expectations. Since then,
the test rounds are more like precautionary measures amid the
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, interest rates and a substantial weakness in
Further, the Fed will test the banks' balance sheet under the
impact of slowdown across economies and severe recession in the
U.S., Europe and Japan, leading to about 50% fall in equity
prices. Other stressful circumstances include unemployment rate
reaching 11.25%, home prices declining nearly 25% and the U.S.
GDP falling 4.75%.
The banks are required to file their capital plans by Jan 6, 2014
to undergo the new tests. They will have to adhere to this
requirement even without any plan of enhancing shareholder value.
The banks intending to boost shareholder value (through dividend
hikes and share repurchases) will have to prove their capability
to reach minimum Tier 1 common equity ratio of 5% through 2015.
Moreover, banks are getting an opportunity to revise their
capital plans, in order to prevent a failure 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 Road to Recovery
Conducting the stress test is a prudent step by the Fed to
evaluate the overall performance of the banking sector. These
tests help banks to gear up and improve their weak capital
levels, which always threaten the economy. In the second quarter
of 2013, the 18 banks increased their Tier 1 common capital to
$836 billion from $392 billion at the end of second quarter 2009.
In addition, stress tests will likely translate into less
involvement of taxpayers' money for the bailout of troubled
While the government has been closely monitoring major banks and
extended aid through various programs, many smaller banks are
still struggling to stay afloat. Though there has been a rebound
in home prices, rising loan defaults and the high unemployment
rate continue to weigh on small institutions. However, if most of
the major banks pass the stress tests, it would be a much-needed
boost in the economic recovery.