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Bank Stress Test: $385 Billion in Losses Wouldn’t Cause Financial Collapse

Let’s say there was a severe global recession in which the unemployment rate soared five percentage points, and there was a heightened period of financial stress, and negative yields for short-term U.S. Treasury securities. Could the big banks survive?

Yes.

So says the Federal Reserve, which drew the conclusion for this most severe hypothetical scenario based on the 2016 bank stress test. It noted that this “severely adverse” scenario projected that loan losses at the 33 participating bank holding companies would total $385 billion during the nine quarters tested.

The biggest banks by market cap include Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC), Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM) and Morgan Stanley (NYSE: MS).

All of these banks, and 28 others, received word from the Federal Reserve on Thursday that they had passed the so-called bank stress test. This is the sixth round of stress tests led by the Federal Reserve since 2009 and the fourth round required by the Dodd-Frank Act. The firms tested represent more than 80 percent of domestic banking assets. The Federal Reserve uses its own independent projections of losses and incomes for each firm.

Since 2013, banks have begrudgingly complied with a wide array of regulations stemming from the Dodd-Frank Act calling for banks to take and pass these tests. As part of the stress tests, banks have been required to submit paper work to the Federal Reserve to prove they are financially healthy enough, especially when it comes to capital, to weather a fiasco similar to the one that caused the financial collapse in 2008.

The stress test results are meant to provide the Federal Reserve with forward-looking information to help them supervise banks and assess their risk profiles. They want to make sure that institutions have robust, forward-looking capital planning processes that account for their unique risks. We learned the hard way after 2008 that many banks did not have sufficient capital to continue operations throughout times of economic and financial stress.

The stress tests put under the microscope banks’ economic variables, including macroeconomic activity, unemployment, exchange rates, prices, incomes and interest rates.

Passing the stress test is crucial in helping banks to be able to increase their dividends and buyback shares. You may recall last year when Goldman Sachs, JPMorgan Chase and Morgan Stanley came pretty close to failing the test. The Fed ordered them to resubmit their capital plans by either decreasing the amount of their dividends or by decreasing the size of their buyback programs. They did so and passed. Interesting, it was the second year in a row that Goldman was asked to resubmit its plan.

Because the banks passed the test under the worst scenarios, pundits are raising questions about whether the stringent compliance requirements are still needed. Most agree, however, that they are still needed considering they provide not only federal oversight, but they also force banks to be critical in making sure their internal financial controls will pass muster.

As noted above, passing the stress tests is crucial to banks being able to increase the size of the share buyback programs, and increase their dividends.

However, I think it would be better for them to increase their. I heard one observer say it best by asking, “when was the last time you heard of a company doubling its share price through buyback programs?” Companies are far more valuable when they increase their dividends instead.

If you are considering the banking sector as an investment, there are some things to keep in mind. Most importantly, remember that banks’ credit quality is getting weaker. However, it’s not weak enough yet to be a deal breaker.

Banks are seen as relatively cheap too, with some of them selling at a 40% discount to book value.

Also expect to see more consolidation and acquisition to be the wave of the future among the smaller banks.

In the meantime, the market is readying for the rest of the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR). Those results will be released on Wednesday, June 29.





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