The Federal Reserve’s stress test for banks gained a lot of attention earlier this week after it published its Comprehensive Capital Analysis and Review (CCAR). While investors certainly have eyed the results, many don’t seem to understand what all the fuss is about. Simply put, these tests seek to ensure that the country’s biggest banks are strong enough to withstand an extreme adverse economic scenario. These scenarios more or less mirror the situation witnessed during the global economic crisis of 2008, so aren’t completely implausible. So even if you’re not an investor in bank stocks, these tests can tell you which banks are best-positioned to withstand a potential economic downturn. Because many of the biggest banks – such as Bank of America (NYSE:BAC), JPMorgan (NYSE:JPM), Goldman Sachs (NYSE:GS), Citigroup (NYSE:C) and Morgan Stanley (NYSE:MS) – have exposure to the issues in the Eurozone, these tests become all the more important.
History of the Fed’s CCAR
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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 in 2009 and 2010, but wasn’t paid 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, as the last thing the government wants to do is use taxpayer money for more bank bailouts.
The Fed ran its stress test on 19 of the country’s biggest financial firms for 2011 – a number that will swell to 31 for 2012 as all banks with assets worth more than $50 billion will come under the scanner.
The Test Scenario
As we mentioned earlier, 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 25 variables that capture various aspects of the global economy.  Of these, 13 variables relate to the domestic economy, and the rest are international variables.
Below are some of the variables considered as part of the supervisory scenario for the stress test:
- The U.S. unemployment rate reaches a peak of 13%. This figure was just under 10% for Q4 2011
- Equity prices witness a 50% drop compared to their value in Q3 2011
- Housing prices dip 21%, represented by a reduction in the house price index
As you can see, the underlying assumption is that things get a lot worse than they currently are. So if these banks can hold their ground in such an extreme scenario, they will be strongly 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.Notes:
- Methodology and Results for Stress Scenario Projections (PDF), Federal Reserve Website [↩]