Will Stress Test Protect Our Money? - Analyst Blog

It's time again for America's biggest banks to flex their financial muscles. Yet another round of stress tests await these banks that need to prove their financial prowess, should another recession befall. Among the targeted banks, six that are susceptible to the European crisis will have to go through even tougher tests this time. But the question is, will this really help us with respect to financial flexibility and protection?

Before finding the possible answers to this question, let's have quick look on the Federal Reserve's stress-test initiatives.

Starting with the latest step, earlier this week, the Federal Reserve ordered the top 31 U.S. banks, with assets of $50 billion or more, to participate in stress tests. These banks will have to submit their plans to the Fed by January 9.

This will mark the fourth round of bank stress tests since 2009. The prior tests were conducted in early 2011, late 2010 and in 2009. Earlier, the periodic stress tests were applicable to the 19 big banks regulated by the Federal Reserve. But more 12 banks with at least $50 billion in assets will now run for the first time.

The Requirements

The banks need to file their capital plans to the Fed by January 9 to undergo the new tests. They will have to adhere to the requirement even if they don't plan to increase dividend payments.

The banks that intend to boost dividends will also have to prove their capability to comply with the upcoming tougher Basel III banking regulations. Those that fail the tests may not be allowed to distribute dividends. However, the banks will get an impetus to take initiatives for raising new capital to meet the Fed requirements. Results will be published in March.

The Aim?

The selected banks would need to demonstrate that they have adequate capital to address potential losses over the next two years under several stressful scenarios.

The environment of the last two rounds of stress tests and the upcoming one are dissimilar to the Fed's first round. The first round, conducted when the country was teetering under tremendous recessionary pressure, was aimed at estimating how much the banks would lose if the economic downturn turned out to be deeper than expected. Since then, the test rounds are more like precautionary measures amid economic recovery.

How Much Tougher This Time?

The six big U.S. banks - Citigroup Inc. ( C ), Bank of America Corp. ( BAC ), JPMorgan Chase & Co. ( JPM ), Morgan Stanley ( MS ), Goldman Sachs ( GS ) and Wells Fargo & Company ( WFC ) - will have an even higher stumbling block to clear as they have significant exposure to the stressed European countries - Greece, Ireland, Italy, Portugal, and Spain - known as the GIIPS.

These banks would have to go through a hypothetical market shock to prove their ability to endure domestic as well as global recession. The hypothetical stress scenario would assume an increase in unemployment to above 13% in early 2013, a decrease in U.S. GDP by as much as 8% plus a significant slowdown in U.S. and global economic activities.

Also, these banks have to prove their ability to keep their core Tier I common equity above 5% even under imaginary stress.

The Story Behind

Though capital strength verification is definitely a necessary step in the midst of economic recovery, this decision was not taken solely by the Federal Reserve. When the recession broke out, the Fed had barred all banks from increasing dividends.

Following sharp cuts in dividends due to increased government intervention, banks had been pressuring regulators for months to let them restore their dividends after they repaid the bailout money. The primary intention of the banks was to attract new investors by enhancing dividend payments. Since 2010, the Fed has been keeping this demand, but only for those banks that pass its stress tests.

Stress Tests: Boon or Bane?

The economic benefits of the stress tests are indisputable. It goes without saying, that these would keep the banks on their toes. Banking biggies would perform under pressure and try to build their weak capital levels, which threaten the economy. The whole drill could ultimately translate into less involvement of taxpayers' money for bailing out troubled financial institutions.

But the most dependable banking names in terms of dividend payment will have to face tougher tests ahead. Naturally, their chances of passing the tests and gaining eligibility to enhance shareholder value are rather dim.

In fact, the challenge is not just contained to the big banks. The story is much the same for the other financial institutions that would find it difficult to raise dividends or buy back more stock.

Moreover, though the government is trying to protect the nation from another recession by forcing U.S. banks to be healthy and strong in terms of capital, this could force them to withdraw their investments from European countries. If this happens, the crisis in Europe will deepen further and backfire on our economy. So the long-term result could be a catch-22 situation.

On the other hand, while the government has been closely monitoring bigger banks and has even extended help through various simulative programs, many smaller banks are still struggling to stay afloat. The government should set policies so that all the industry participants contribute to the overall profitability.

If most of the major banks pass the stress tests with their money power, the domestic economy will recover in leaps and bounds. But in their scurry to succeed, the banks could be tempted to manage funds immediately by liquidating their investments in weak countries. This would end up in a fiasco, an economic disaster that no one wants.

BANK OF AMER CP ( BAC ): Free Stock Analysis Report

CITIGROUP INC ( C ): Free Stock Analysis Report

GOLDMAN SACHS ( GS ): Free Stock Analysis Report

JPMORGAN CHASE ( JPM ): Free Stock Analysis Report

MORGAN STANLEY ( MS ): Free Stock Analysis Report

WELLS FARGO-NEW (WFC): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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