How A Bank Stress Test Works
Recently released European Banking Authority (EBA) stress test results have many banks breathing a sigh of relief and some banks feeling a world of pain.
While stress tests like this one are certainly helpful when it comes to easing fears about a future financial crisis, many investors have no idea what it means for a bank to “pass” or “fail” a stress test.
How Does A Stress Test Work?
In general, the idea behind a stress test is to determine if banks (or other institutions) have adequate capital levels to safely survive a downturn in economic conditions.
Regulators typically look at banks’ “capital ratios,” which are measures of how much of a bank’s finances come from internal sources, such as operational cash flows and shareholder funding, versus how much comes from borrowing from outside sources. During times of financial uncertainty, outside financing can become unreliable, and if banks do not have adequate internal capital available, they run the risk of becoming insolvent.
United States SCAP Test
The first stress test that came about as a result of the 2008-2009 U.S. financial crisis was the 2009 Supervisory Capital Assessment Program (SCAP). This initial stress test was conducted by the Federal Reserve, and it tested the financial strength of 19 of the largest U.S. banks under two different scenarios.
The first scenario was a baseline scenario that determined how well-capitalized the institutions were based strictly on the real-world economic conditions at the time. The other scenario took a look at the banks’ expected capital levels under hypothetical future conditions in which the economy continued to deteriorate.
The metric of choice for the Federal Reserve for these tests was something called “Tier 1 common capital.” A bank’s Tier 1 ratio is calculated by dividing the sum of a bank’s common capital (primarily common stock and disclosed reserves) by its risk-weighted assets (a sum of all the assets on a bank’s balance sheet weighted by credit risk).
The regulators decided nine banks "passed," including: JPMorgan Chase & Co. (NYSE: JPM), Goldman Sachs (NYSE: GS) and U.S. Bancorp (NYSE: USB), while 10 banks "failed," including: Bank of America Corp (NYSE: BAC), Citigroup Inc (NYSE: C) and Wells Fargo & Co (NYSE: WFC).
The banks that failed were required by the Fed to raise additional Tier 1 capital.
The United States CCAP Test
Starting in 2011, large American banks have been subject to an annual Comprehensive Capital Analysis and Review (CCAR) stress test. As required by CCAR, banks must submit capital plan proposals (including planned dividend payments and share buybacks) to the Federal Reserve. The Fed determines whether the proposed capital plans would allow the banks to continue to meet required capital ratios during stressful economic conditions.
This year’s hypothetical economic scenario included a 50-percent decline in the stock market, 11.25 percent unemployment, real GDP drop of nearly 4.75 percent and a fall in commercial real estate prices of nearly 35 percent.
2014 EBA European Bank Stress Test
Ninety-nine banks, such as Germany’s Deutsche Bank AG (NYSE: DB), the UK’s Barclays PLC (NYSE: BCS), and Ireland’s Bank of Ireland (NYSE: IRE), passed the EBA test. Twenty-four banks, including National Bank of Greece (NYSE: NBG), failed by dropping below the required common equity ratio of 5.5 percent or higher during the adverse condition. In addition, as many as 40 banks could need to raise further capital before increased capital levels — likely a 7 percent ratio — are required in four years.
What Stress Test Results Mean For Investors
With so many financial institutions growing to unprecedented size over the past couple of decades, the systemic risk associated with the collapse of any of these large institutions continues to rise. While stress tests do not eliminate the risk of financial disaster, these tests do ensure that big banks are taking steps to adequately prepare for tough times down the road.
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