Not-So-Stressful Tests

(Editor's Note: MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.)

The Fed announced the results of its bank stress tests Tuesday, which likely contributed to a late afternoon rally in equity markets. The results will be sliced and diced in coming days, but overall, the results seem generally positive and underscore just how much cash and core capital banks have squirreled away over the last few years.

The report tested bank capital levels assuming current dividend and share buy-back plans were left in place, along with a 21% decline in housing prices, 13% unemployment and a 50% decline in stock prices. It’ll be hard for critics to say regulators let the banks off easy—such a scenario seems fairly dramatic, especially considering current stock and home valuations aren’t exactly bubbly.

Fifteen of the nineteen banks passed their capital requirements, with one passing on its most important capital ratios and just missing a leverage ratio. (See Exhibit 1, which shows post-stress results on bank capital levels.) Of the other three to miss, one missed by 0.1% and the other by 0.2%. (Metlife did fail one of the leverage ratios by 0.1% but passed the capital level.) These banks must resubmit plans and will be restricted on share buy backs and dividends until they pass, but the miss seems pretty manageable.

Exhibit 1: Summary of Stress Tested Bank Capital Levels

Source: Federal Reserve

Some critics argue the stress test was largely counterproductive, causing banks to hoard cash unnecessarily during a period when the US economy needs growing credit to goad economic growth. And we’d largely agree banks haven’t had unfettered incentive to make loans as they deemed appropriate. But if the stress tests help boost sentiment, that’s an incremental positive. What’s more, moving past this stress test means passing banks can shake off some additional regulatory strictures (e.g., limits on buy backs and dividends)—another additional positive for the economy which counts on banks to assist in the process of allocating capital to where its used most effectively and efficiently.

A healthy banking system provides a key backdrop for economic growth, and today’s stress tests continue to show the US is increasingly headed in that direction.