The Fed wants to “ensure that institutions have robust, forward-looking capital planning processes” and “ensure that institutions have sufficient capital to continue operations throughout times of economic and financial stress”.
What the Fed really means is they want to know if banks could withstand another economic downturn like what we saw in 2008…with a crisis in the euro zone mixed in for good measure.
Last week the Fed announced a third round of stress tests for US banks. The first round, in the spring of 2009, opened the way for banks repay TARP bailouts. The second round, finished in March, allowed banks to boost dividends.
In those first rounds, 19 of the largest banks were tested (those with $100 billion or more in assets)…but now 31 will be subjected to this latest round (banks with $50 billion or more). More banks will be tested…and the tests will be more stringent. The six largest banks (Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, JPMorgan Chase and Wells Fargo) will face tougher hurdles than others. They will be tested to see if they could withstand 13% unemployment, and an 8% drop in GDP, and a 52% drop in the markets. Add to that a “hypothetical global market shock” coming out of the euro zone, and you don’t have a recession… you have an economic tsunami.
As bad as that sounds, its not cause for alarm just yet. The stress test scenario is not a reflection of the Fed’s outlook, or the result of new fears of a deterioration in US banks. It’s a requirement under Dodd-Frank.
Banks have until January 9th to submit their capital plans to the Fed. They have until then to show that they can maintain a 5% cushion on the sidelines. And any bank that can’t show an adequate plan will face restrictions…meaning they will not be allowed to increase dividends or buy back shares. The point is to prevent the capital depletion that occurred during the financial crisis, as banks bought back shares and paid out dividends while their loan portfolios fell apart.
But we don’t need Dodd Frank or the Fed’s stress tests to know that banks are questionable. The markets have decided that already. The sector is lagging all others…down -26.3% year-to-date. And a proxy for the space, Financial Select Sector SPDR (XLF), is in a long-term downward trend (and is also down over -26% so far this year), and signaled a long-term sell back in June.