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Investors Await Latest Round of Bank Stress Test Results

Bank officials and their shareholders are holding their breaths as they wait to see how they fared under the Federal Reserve’s stress tests.

They are also readying for even more stringent capital requirements that the Fed is putting in place for them for future stress tests. These measures are mainly meant to make sure that banks have enough capital, and acceptable debt exposure, to avoid, and deal with the mess we saw when the financial markets collapsed in 2008.

 · What’s there to stress about?

Investors that held bank stocks prior to 2008 had little to stress about. They enjoyed regular dividends from banks, like JP Morgan (NYSE: JPM), Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC) and Citigroup (NYSE: C).

However, after the markets collapsed in 2008, that changed. Banks were teetering on the edge of disaster. Lehman Bros. was the first casualty, filing for bankruptcy after not being able to cover its obligations. Concerned that other banks would go the way of Lehman, the federal government bailed out the others to the tune of $475 million. The program called Troubled Asset Relief Program (TARP) was meant to help stabilize America’s banking system during the financial crisis.

While the goal was admirable, many investors frowned. Investors in banks that received funds from the saw their dividend payments slashed shortly after 2008. Dividend.com pointed out that after TARP, dividend yields surged as the share prices fell.

 · The birth of the stress act

From TARP, came the Dodd-Frank act and these stress tests. The act requires national banks and federal savings associations with more than $10 billion of consolidated assets to conduct annual stress tests. The tests are meant to assess banks’ risk profiles and capital adequacies. The goal is to ensure that institutions have robust, forward-looking capital planning processes that account for their unique risks, and to help ensure that institutions have sufficient capital to continue operations throughout times of economic and financial stress, according to the Office of the Comptroller of Currency.

The OCC uses the stress test results to determine whether additional analytical techniques are needed to identify, measure and monitor risk. These stress test results can also be used to support ongoing improvement in stress testing practices when it comes to assessing a bank’s capital adequacy and overall capital planning.

 · More stringent requirements to come

The stakes are huge for banks when it comes to passing the stress tests. Passing allows them to make capital distributions like share buybacks and dividend payouts, without the Fed’s approval. Failing could negatively affect a bank’s share price as the main pluses of investing in them are not available until the failing bank passes and receives Fed approval.

Federal Reserve officials plan to go further in toughening the requirements for banks as they relate to the annual stress tests. This raises concerns about the Feds possibly going too far in their regulation of banks, which could negatively affect banks’ profitability.

The more stringent guidelines could make it harder for banks to pass the stress tests. When that happens, the regulations handicap them in being able to increase dividend payouts or participate in share buyback programs.

Fitch Ratings found that banks’ dividend and buyback requests through the annual comprehensive capital analysis and review (CCAR) process have increased in recent years. The median capital distribution request rose to 1.2% of stressed capital in 2015 from 0.8% of stressed capital in 2013. In a statement released on June 1, the rating agency stated that it believed dividend and buyback requests could rise again this year and that banks are likely to press the 30% dividend payout threshold, which the Fed has said it will scrutinize more closely.

 · It’s for the best

You may recall last year when Bank of America flunked the stress test, and the Fed rejected its request to increase its dividend. The bank went into proactive mode, and focused on building its capital and absorbing the losses from its mortgage business. This helped put it on a more solid financial footing.

Investors should take solace in the bank stress tests being key to banks being able to continually increase value to their shareholders. No one wants to see a repeat of 2008. On that same note, we don’t want to see the regulatory oversight, via increasingly stringent requirements, handicap banks.

The banking sector has enjoyed recovery over the past few years, although it has been a slow one. Banks seem to have become more comfortable with the stress test process, and they’ve become “creative” with their capital requests, notes Fitch.

For these reasons, I continue to see banks as providing long-term investment opportunities.

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