The Dodd-Frank Wall Street Reform and Consumer Protection Act has made it mandatory for certain financial companies to conduct stress tests to determine whether they have sufficient capital to absorb losses and to support operations during adverse economic conditions.  The objective is to ensure that that they do not pose risks to their communities, other institutions, or the broad economy, and these tests are therefore forward-looking.

Dodd Frank Act stress tests

Banking companies having total assets greater than $50B, and certain non-banking but financial companies designated by the Financial Stability Oversight Council, would be subjected to the Dodd Frank Act (DFA) stress tests thrice a year – once under regulatory supervision, and semi-annually under self-management. The results of these tests are to be made public.

UBS analysts Brennan Hawken, David Eads and Daniel Guckian analyze the latest mid-year, self-conducted stress test results declared by major national banks and brokers in their report dated September 16, 2013. The primary focus is the identification of major changes with respect to the previous such tests held in March.

Capital adequacy

A key finding is that the capital position of the industry is healthy, and that augurs well for the Fed-administered test coming up early next year. Stressed Tier 1 capital ratios are up 1.4 percent on an average basis at the end of the period under study, and up 1.2 percent average on a minimum basis as per the table below.

banks stress test

Morgan Stanley (NYSE:MS)’s result is above average and UBS feel that could be due to drivers in the Wealth Management business and more stable earnings power.

Loan losses in a severely stressed scenario

An analysis of pre-tax net losses in a severely stressed scenario reveals two interesting features.

Loan losses were down somewhat, though Bank of America Corp (NYSE:BAC) showed the most impressive decline of 70 bps, and Citigroup Inc (NYSE:C) was flat.

Secondly, trading shocks are showing a declining trend, and this should be another positive during the Fed stress test.

Here are the tables for this data:

Banks Stress Test

Conclusion

UBS are, however, cautious on the bank and brokerage sector, despite the above positives, because of its valuation at 1.1 times tangible book value and muted growth in earnings and revenue.