Another Round of Stress Tests Ahead - Analyst Blog

America's largest banks will have to go through another round of stress tests to prove that they will be able to confront another recession with their financial strength, the Federal Reserve said Wednesday.

All of the 19 largest banks regulated by the Federal Reserve including Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM) and Wells Fargo & Company (WFC) would need to demonstrate that they have adequate capital to address potential losses over the next two years under several scenarios.

The environment of the latest round of stress tests are dissimilar with the Fed's first round in that the earlier ones were conducted in 2009 to estimate how much banks would lose if the economic downturn proved even deeper than expected as the country was teetering under tremendous recessionary pressure. The latest stress tests are basically a precautionary measure amid economic recovery.

The Inside Story

Though capital strength verification is definitely a necessary step in the midst of the economic recovery, this is not an independent decision of the Federal Reserve. When the recession had struck, the Fed had barred all banks from increasing dividends.

Following a sharp reduction of banks' dividends due to increased government intervention as a result of the bailout program, banks have been pressuring regulators for months to let them restore their dividends after they had repaid the bailout money. The primary intention of banks is to attract new investors by enhancing dividend payments. The Federal Reserve has finally given in to this demand.

The Requirements

All the 19 largest banks that had gone through first round of stress tests during the financial crisis in 2009 must file their capital plans by January 7, 2011 to undergo the new tests. They will have to adhere to this requirement even without any plans to increase dividend payments. The banks that do intend to boost dividends will have to prove in addition that they have the capability to comply with the upcoming tougher Basel III banking regulations.

Failing the test, a bank will have to take initiatives to raise new capital to meet all the requirements.

The Disqualified Banks

Many of the regional banks that have still not repaid the bailout money in full will not be allowed to increase their dividend payments, if they wish to do so. As soon as these banks repay bailout money they will be allowed to increase dividend payments, provided they meet the requirements to pass the stress test. Indirectly, the latest stress test may accelerate the pay-back of bailout money by small banks.

On the Road to Recovery

The economic benefits of the stress tests are indisputable. These would somewhat reconstruct the banks' weak capital level, which threatens the economy. Also, this could ultimately translate to less involvement of taxpayers' money for bailing out troubled financial institutions.

Is this too early to let the big banks increase dividends? While the bigger banks benefited greatly from the various programs launched by the government, many smaller banks are still weak. Tumbling home prices, soaring loan defaults and a high unemployment rate continue to take their toll on small institutions.

With the industry absorbing bad loans made during the credit explosion, the trouble in the banking system has worsened, intensifying the possibility of more bank failures. The government should set policies to help all the industry participants contribute to the overall profitability first.

However, if most of the major banks pass the stress test and consequently get the permission from Federal Reserve to increase dividend payment, this will definitely accelerate the pace of economic recovery.

 
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