Yesterday, the Federal Reserve announced the results of its latest round of stress tests on American banks, Bloomberg reports. The stress tests, which were authorized by the Dodd-Frank Act, seek to simulate what would happen to banks’ balance sheets in times of economic hardship. Put into place after the financial crisis several years ago, the tests seek to prevent a repeat of bank failures by providing for worst case scenarios before they occur.
This time, though, the Federal Reserve’s results may be harsher than those obtained by banks themselves. Banks had conducted an independent series of stress tests this past September, which showed that the banking industry was healthy as a whole and that the sector had recovered somewhat from the disasters of 5 years ago. The Fed’s methods, however, incorporate historical and industry-wide data into their analyses, much more so than individual banks, which tend to conduct their tests on a more case-by-case basis.
A big difference between the two approaches is that the Fed anticipates assets rising in times of economic distress, which simulates historical trends. Most banks tend to consider that assets will decrease in value during recessions, an approach that the Fed has claimed is completely unjustified by past experiences.
This could seriously impact the amount of capital that banks are required to keep on hand. Banks are bound by a capital ratio, meaning that, on a basic level, they must keep a certain percentage of their risky assets on hand as capital. Usually, the floor proportion for a capital ratio is 5 percent, with some banks choosing to keep more than that amount if they believe it to be necessary. Projections in which assets increase necessitate the maintenance of additional capital, while forecasts in which assets decrease forego the need to raise capital in times of hardship.
One implication of this is that some banks, including Ally, have been asked to raise more money in the short-term in order to be better able to support their capital ratios. A different implication is that it limits share buyback programs and dividends, because banks will have less money to spend on such programs if they must keep more capital in reserve. Even banks that will still be able to engage in such programs will have to do so on a lesser scale, making cutbacks to funds that would be, directly or indirectly, headed for shareholders.
One good piece of news is that it appears as if all of the major American financial institutions will be able to pass the tests, perhaps with some work needed. There is no widespread concern of a second financial meltdown at this time, making the situation even calmer still. Even so, the mere possibility of another crisis in the banking sector is causing regulators to be tougher toward banks this time around.