Everything You Need to Know About the Stress Tests
Mar 8th 2013 5:37PM
Updated Mar 8th 2013 7:00PM
For the first time, the Federal Reserve ran through the Dodd-Frank-mandated banking stress tests. That made what was a one-step stress-test process last year -- the Fed's Comprehensive Capital Analysis and Review -- a two-step process this year.
Both tests examine how bank balance sheets would hold up under the pressure of an extremely adverse economic scenario -- a scenario that this year included a severe recession in the U.S. combined with a housing market drop, rising unemployment, a global financial shock, and marked slowdowns in the eurozone, Japan, and the developing Asian countries. But while the CCAR looks at banks' capital plans -- which may include, for instance, raising dividends -- the Dodd-Frank tests assume consistent capital plans.
Ally Financial -- the former GMAC -- managed to fail the Dodd-Frank test pretty seriously. But it was alone in that feat. All of the other 17 banks tested had minimum stressed capital ratios that were comfortably above required minimums.
Of particular focus in these tests is the Tier 1 common ratio. The mandated minimum level by regulators -- which we could reasonably call the pass/fail line in these tests -- is 5%.
Some of the banks like Bank of New York Mellon and State Street, which are primarily banks for banks and maintain solid, low-risk balance sheets, breezed through the tests. Others, like Goldman Sachs and Morgan Stanley cut it a bit closer thanks to their trading portfolios and the hits they were expected to take in the hypothetical global financial shock.
Big banks Bank of America and Citigroup were probably the most watched -- and certainly the most talked about -- coming into the tests. Both banks passed the tests easily, though if one stood out as a particular surprise, it was Citi and its strong showing. Bank of America, meanwhile, though improving on its CCAR showing from last year, was perhaps more of a disappointment (particularly if you ask this Fool).
But investors in the individual banks will certainly want to get beyond the aggregates and take a closer look at the bank-by-bank results. To help with that, we've put together a cheat sheet for each bank that will help you get up to speed quickly on how each bank fared through the first round of stress testing.
Click on the name of the company to see the full breakdown:
In the end, if there's one key takeaway from the first round of stress tests, it's that the results suggest that the country's major banks could rack up close to $200 billion in losses and still maintain a median 7.7% tier 1 common ratio. That's a huge change from just a few years ago -- and a big relief.
Some readers may scoff at the tests and how much comfort they can give us. After all, what if the next shock-and-awe financial meltdown doesn't look like the one that the Fed has created here? While that's a reasonable view, it misses the bigger picture. Banks were able to come out the other side of these tests looking good largely because they simply have a lot more capital than they did in 2007.
A wooden house may fold under hurricane conditions, but if you bolster those walls with a brick backing, it can withstand a lot more. There's little doubt in my mind that bank balance sheets are in a very good place right now. If there's something to be worried about, it's not in the here and now. Instead, it's whether the banks will keep up that level of safety, or shuck it down the road for a shot at a fatter bottom line.
One big stress-test winner
Citigroup stood out as a big upside surprise in the first round of stress tests. Does that mean that investors should be jumping on an opportunity to buy? To help figure out whether Citigroup deserves a spot on your watchlist, I invite you to read our premium research report on the bank today. We'll fill you in on both reasons to buy and reasons to sell Citigroup, and what areas that Citigroup investors need to watch going forward. Click here now for instant access to our best expert's take on Citigroup.
The article Everything You Need to Know About the Stress Tests originally appeared on Fool.com.Matt Koppenheffer owns shares of Bank of America and Morgan Stanley. The Motley Fool recommends American Express, Goldman Sachs, and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, Fifth Third Bancorp, JPMorgan Chase, KeyCorp, PNC Financial Services, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.