Don't let the name fool you, the stress tests that the nation's biggest banks must undergo each year have become much less stressful for investors. Not only have large banks grown accustomed to the exercise over the past few years, but banks have far more capital nowadays than is needed to pass the tests.
Bank of America (NYSE: BAC) offers a case in point.
The purpose of stress tests is straight forward. They're to "help make sure that banks will be able to lend to households and businesses even in a serious recession by ensuring that they have adequate capital to absorb losses they may sustain," the Federal Reserve explains .
The key is capital. If a bank has enough capital to survive an economic downturn akin to the financial crisis and continue lending to consumers and businesses, then it will pass the test. If it doesn't, then it will fail.
The assumptions in this year's test are severe, but they essentially track last year's test. Among other things, the Fed assumes that the unemployment rate spikes to 10%, gross domestic product falls 6.5%, stock prices lose half their value, home prices drop by 25%, and commercial real estate prices fall 35%.
To determine how a bank's capital will weather this storm, the variable to watch is the common equity tier 1 capital ratio, or CET1 ratio. This compares how much highly liquid capital a bank has relative to a risk-weighted measure of assets.
The details underlying these calculations are complicated, but all an investor needs to know is that a bank must maintain a CET1 ratio of at least 4.5% to pass the first round of the stress tests, known as DFAST, the results of which are due out on Thursday.
Going into this year's test, Bank of America's CET1 ratio was 12%, which marks an improvement over last year, when it entered the test with a 11.6% CET1 ratio. I won't belabor you with the math, but this means that Bank of America has $104 billion more capital than prescribed by the 4.5% regulatory minimum.
Bank of America Capital Metric
Cushion over regulatory minimum
Estimated loss in 2016 DFAST
Excess CET1 capital over regulatory minimum and estimated loss in 2016 DFAST
Source: Bank of America, author's calculations.
This gives Bank of America a lot of wiggle room. And it's much more than the bank was projected to lose in last year's test, when the Fed estimated that the North Carolina-based bank's net loss over the nine-quarter horizon would add up to $36.3 billion.
Assuming Bank of America experiences a similar loss in this year's test, it would still have $68 billion in common equity tier 1 capital above the 4.5% benchmark that's needed to pass the test. Absent a completely unforeseen event, that's more than enough to allow shareholders in the nation's second biggest bank by assets to safely assume that it will sail through the Fed's gauntlet this year.
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