The environment of the last two rounds of stress tests and the upcoming one are dissimilar to the Fed’s first round. The first round, conducted when the country was teetering under tremendous recessionary pressure, was aimed at estimating how much the banks would lose if the economic downturn turned out to be deeper than expected. Since then, the test rounds are more like precautionary measures amid economic recovery.
How Much Tougher This Time?
The six big U.S. banks — Citigroup Inc. (C), Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM), Morgan Stanley (MS),Goldman Sachs (GS) and Wells Fargo & Company (WFC) — will have an even higher stumbling block to clear as they have significant exposure to the stressed European countries — Greece, Ireland, Italy, Portugal, and Spain – known as the GIIPS.
These banks would have to go through a hypothetical market shock to prove their ability to endure domestic as well as global recession. The hypothetical stress scenario would assume an increase in unemployment to above 13% in early 2013, a decrease in U.S. GDP by as much as 8% plus a significant slowdown in U.S. and global economic activities.
Also, these banks have to prove their ability to keep their core Tier I common equity above 5% even under imaginary stress.
The Story Behind
Though capital strength verification is definitely a necessary step in the midst of economic recovery, this decision was not taken solely by the Federal Reserve. When the recession broke out, the Fed had barred all banks from increasing dividends.
Following sharp cuts in dividends due to increased government intervention, banks had been pressuring regulators for months to let them restore their dividends after they repaid the bailout money. The primary intention of the banks was to attract new investors by enhancing dividend payments. Since 2010, the Fed has been keeping this demand, but only for those banks that pass its stress tests.
Stress Tests: Boon or Bane?
The economic benefits of the stress tests are indisputable. It goes without saying, that these would keep the banks on their toes. Banking biggies would perform under pressure and try to build their weak capital levels, which threaten the economy. The whole drill could ultimately translate into less involvement of taxpayers’ money for bailing out troubled financial institutions.
But in their scurry to succeed, the banks could be tempted to manage funds immediately by liquidating their investments in weak countries. This would end up in a fiasco, an economic disaster that no one wants.