The Fed’s Stress Test: The Results Are In

Do the results of the Fed’s recent stress test mean more confidence for business?

The Fed has cleared the capital plans of all 34 banks yesterday, June 28th, surging bank stocks in after-hours trading. The results of the Fed stress tests have investors at ease, coming off strong from the tightened regulatory shackles placed on big banks after the 2008 financial crisis. It is the first time that every bank that qualifies for the Fed’s tests, classified as banks with over $50 billion in assets, has passed. Capital One passed conditionally on its ability to address weaknesses within 6 months. In lieu of these results, big banks have declared increased dividend payments to be rolled out to shareholders in the coming quarters.

The Fed’s annual stress tests aim to reduce banks’ leverage on capital reserves. The tests challenge a bank’s capital reserves, and ensure that it will be able to absorb unforeseeable losses as many banks faced in the 2008 financial crisis. The tests involve complex mathematics and assess hypothetical scenarios such as increased unemployment, falling oil prices, and a recession to see how each bank’s capital plan would fare under unrelenting financial environments.

Banks are tested to see if they can continue lending operations in these circumstances. Banks are forced to hold capital levels equal to 5% of its assets, limiting banks’ leverage ratio of 20:1 as opposed to the much higher levels found pre-crisis.

To assess the foundational structure of these large banks, the Fed runs quantitative and qualitative tests. The quantitative tests look at bank’s capital levels. The Fed concerns mainly Tier 1 capital, money that comes from common stocks, retained earnings, or preferred shares. The qualitative component of the stress tests assesses a bank’s risk management and risk assessment capabilities. Banks with assets between $50 billion and $250 billion are exempted from the qualitative portion of the tests but are required to submit a capital plan regardless.

Bank of America (NYSE: BAC), Goldman Sachs (NYSE: GS), J.P. Morgan Chase (NYSE: JPM) are some of the banks that received a jumpstart from investors, who continue to wait for pro-business tax reform, loosening financial regulations, and interest rate increases to boost big bank earnings. After the Fed released this year’s results, banks have boosted dividends to shareholders. Citigroup has planned to pay out higher dividends equal to 132% of projected earnings, greater than the 110% ratio analysts expected.

The Fed’s results bring a glimmer of light to otherwise dull recent months with flattening yield curves, which affect bank profits, selloff worries in the market, and unimpressive economic data. Where financials will end up by year’s end is still a tossup, but financials have had a positive YTD growth, 0.78%, if it is albeit behind the S&P and the Dow.

Aaron Choi is a student at New York University's Stern School of Business.

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