The Fed’s Stress Test: Here’s Why It Matters

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The Federal Reserve released the summary results of its stress test for banks on March 7, and these figures have been quoted, analyzed and dissected many times over already. [1] Here we try to simplify the key points to put these tests in perspective for you.

Simply put, the stress tests – a part of the Fed’s annual Comprehensive Capital Analysis and Review (CCAR) for banks - seek to ensure that the country’s biggest banks are healthy enough to withstand an extreme adverse economic scenario. These scenarios are more or less based on the situation witnessed during the global economic crisis of 2008, so they aren’t completely implausible.

So why all this fuss over them, you ask. It is because these tests can tell which banks are best-positioned to withstand a potential economic downturn – an important piece of information not just for an investor in the financial sector, but for any individual with a bank account with them. Additionally, as many of the biggest banks, including Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS), Citigroup (NYSE:C) and Morgan Stanley (NYSE:MS) have a substantial exposure to the Eurozone, which is still struggling with weak economic growth, these tests become all the more important.

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History of the Fed’s CCAR

The idea of a comprehensive stress test for banks first occurred to the Fed in the aftermath of the 2008 global recession. It was carried out at the end of 2009 and 2010, but didn’t receive nearly as much attention. However that changed in 2011, with the European debt situation becoming increasingly disconcerting and threatening the stability of many global financial institutions. As a result the stress test became an important tool for the Fed to regulate how banks maintain and use their capital since the last thing the government wants to do is use taxpayers money for more bank bailouts.

The Fed ran its stress test on 18 of the country’s biggest bank holding companies (BHCs) this year – one missing in the list was Metlife (NYSE:MET) since it deregistered as a bank holding company in 2012.

The Test Scenario

The purpose of the stress test is to ensure that the banks have enough capital to lend to customers and businesses even under extremely trying economic conditions. The test scenario includes 26 variables that capture various aspects of the global economy. [2] Of these, 14 variables relate to the domestic economy and the rest are international variables.

The main domestic variables considered as part of the supervisory scenario for the stress test:

  • The U.S. unemployment rate reaches a peak of 12%. This figure was 7.8% at the end of Q4 2012.
  • Equity prices witness a 50% drop compared to their value in Q3 2012.
  • Housing prices dip 20% by the end of 2014, represented by a reduction in the house price index. The index has shown a healthy quarter-on-quarter growth since early 2012.

The 12 international variables capture the impact of a fall in real GDP growth, inflation, and the U.S./foreign currency exchange rate for the four country/region blocks of the Eurozone, the United Kingdom, developing Asia, and Japan.

The underlying scenarios is that things get a lot worse than they currently are and so if these banks can hold their ground in such an extreme scenario, they will be well positioned to withstand an adverse, but more probable scenario in the coming quarters.

This is the first article in our series on the Fed’s Stress Test and its implications for the public at large. We will detail the results of the test for individual banks in the days to come.

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Notes:
  1. Federal Reserve releases summary results of bank stress tests, Federal Reserve Website, Mar 7 2013 []
  2. Methodology and Results for Stress Scenario Projections (PDF), Federal Reserve Website []
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