Goldman Sachs (NYSE:GS) hit the ground running on Monday. Shares of the financial institution — which is due to join the Dow Jones Industrial Average in just a few days — advanced as much as 2.33 percent in afternoon trading, outpacing a 1 percent gain across the financial industry after it disclosed the results of its 2013 Dodd-Frank Act Mid-Cycle Stress Tests.
As one of about 34 banks with domestic assets worth more than $50 billion, Goldman Sachs is required by Section 165(i)(2) of the Dodd-Frank Act to conduct two stress tests each year, one developed by the Federal Reserve (which is administered in January) and one developed by the bank itself. The stress tests are broken into three scenarios: baseline, adverse, and severely adverse. The firm is required to publish a summary of its results based on the severely adverse scenario.
In effect, the stress test is designed to gauge how well-prepared a financial institution is for economic calamity. This type of testing is meant to expose weaknesses before they become monumental problems. As Goldman puts it, “The internally developed, severely adverse scenario is expected to capture a company’s vulnerabilities and firm-specific risks that would impact its activities and results. Our goal is to hold sufficient capital to ensure we remain adequately capitalized after experiencing a severe stress event. We construct a severely adverse scenario that is tailored to particularly stress our risks and our vulnerabilities.”
So what does a severely adverse scenario look like to Goldman Sachs? In a phrase: catastrophic economic contraction. The severely adverse scenario uses parameters GDP contraction of up to 8 percent in a single quarter and unemployment rates above 11 percent for multiple quarters. It’s important to point out that the firm’s scenario assumes low inflation and low interest rates.
In this scenario, the firm expects to suffer trading losses of up to $20 billion as equities lose nearly 40 percent of their value, similar to the loss suffered during the Great Recession. The firm projects that it would log a net loss of $6.2 billion over the nine-quarter period in question, pulling in just $15.5 billion in revenue.
But still, at the end of the day, the bank expects that it would maintain a Tier 1 common ration of at least 8.9 percent during the shock, well above the 5 percent minimum established by new regulations. This is also well above the 5.8 percent that the bank scored during the test administered by the Fed in March.
Goldman reported stress tests results on Monday alongside Citigroup (NYSE:C), KeyCorp (NYSE:KEY), and Capital One Financial Corp. (NYSE:COF). Citigroup’s presentation on its results are embedded below. Citigroup stock was up 1.25 percent in afternoon trading.