The Federal Reserve has asked top 30 banks in the United States to make sure that they have enough buffering capital to withstand the worst economic conditions. The Fed laid out three scenarios banks have to test against, and asked lenders to submit their detailed capital plans by January 7, 2013.
The Federal Reserve made it clear that they are not making any economic forecasts. The central bank is putting hypothetical “severely adverse scenarios” to assess the strength of the country’s financial institutions. The Fed started stress tests during the 2009 economic crisis to restore confidence in financial institutions, after Lehman Brothers Holdings Inc. (PINK:LEHMQ) and Bear Stearns collapsed.
The first scenario is that the unemployment rate rises from 7.9 percent in October to above 12 percent by the end of 2013. The second scenario is a sharp slowdown in China, coupled with a deeper US recession, where the real GDP of the United States declines by about 5 percent. Recession in the Eurozone, the U.K., and Japan is also part of the second scenario. The third scenario is a 50 percent decline in the equity prices and 20 percent decline in real estate prices.
The banks must evaluate how their capital buffers will withstand if all three conditions occur at the same time. They must make a convincing argument that they recognize the risks very well, have a capital plan in place, and they are able to execute capital planning effectively.
The Federal Reserve itself will conduct these tests on 19 of the largest banks, including JPMorgan Chase & Co. (NYSE:JPM), Bank of America Corp (NYSE:BAC), Citigroup Inc. (NYSE:C), Wells Fargo & Company (NYSE:WFC), and Goldman Sachs Group, Inc. (NYSE:GS). The remaining 11 banks will test themselves against the three scenarios and submit their reports to the central bank.
In last year’s test, the Fed assumed a recession, coupled with a 50 percent decline in stock prices and an unemployment rate as high as 13 percent. But this year, the central bank has assumed a steeper slowdown in Asia, including a sharp decline in the economic activity of China.
Though harsh, the test conditions aren’t as bad as what we witnessed from 2007 to 2009. Unemployment rates jumped from 4.7 percent in November 2007 to over 10 percent at the beginning of 2009. Real GDP declined 8.9 percent in just one quarter, and real estate prices tumbled by over 30 percent.
The Federal Reserve said that the top 19 banks increased their Tier 1 common capital from $420 billion in Q1 2009, to $803 billion in Q2 of 2012. The Fed released the revised guidance after Citigroup, MetLife, Ally Financial, and SunTrust Banks failed the stress tests conducted in March.
FDIC and Office of the Comptroller of the Currency will also work with Federal Reserve in conducting stress tests. Additionally, over 100 financial institutions having $10 billion each will conduct stress tests. The regulators clarified that community banks with less than $10 billion will not have to conduct the tests required by big banks.
Raymond James & Associates views this move positively. Analysts believe that banks can be more aggressive with their capital distribution plans without risking “failing” the stress test based on dividend payout or buyback assumptions.
They note that the one-time adjustment factor bodes positively for those that they view as better positioned to return capital – The Bank of New York Mellon Corporation (NYSE:BK), BB&T Corporation (NYSE:BBT), Fifth Third Bancorp (NASDAQ:FITB), Huntington Bancshares Incorporated (NASDAQ:HBAN), JPMorgan Chase & Co. (NYSE:JPM), KeyCorp (NYSE:KEY), State Street Corporation (NYSE:STT), U.S. Bancorp (NYSE:USB), and Wells Fargo & Company (NYSE:WFC). However, those exhibiting the largest increase in their projected total payout ratios may be viewed as the biggest “winners.” We see these as Bank of America Corp (NYSE:BAC), Citigroup Inc. (NYSE:C), Regions Financial Corporation (NYSE:RF), and SunTrust Banks, Inc. (NYSE:STI).