Stress Tests 2014: Can Banks Withstand Increasing Interest Rates?

Investors and analysts alike are confident the six largest United States financial institutions — JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup, Wells Fargo, Morgan Stanley, and Goldman Sachs — will pass the annual stress tests conducted by the Federal Reserve and show they are able to withstand prolonged market stress like the financial industry experienced between June 30, 2008 and December 31, 2008 — the worst of the financial crisis. The results, which are set to be released March 20, will likely reflect both increased capital levels and the experience banks have amassed in the numerous tests conducted since 2009. “We know the banks have enough capital, that’s not the question,” Sterne Agee & Leach analyst Todd Hagerman told Bloomberg in an interview. “It’s more about whether there is something in the capital-planning process that the Federal Reserve might object to.”

On the eve of 2014 stress tests, a source familiar with the Federal Reserve’s thinking told CNN’s Fortune that the central bank recently informed several banks that it requires more data on their trading operations, and an official request is expected to come in the next few days. More specifically, the publication’s sources believe the Fed will ask banks to show how their trading operations would perform under as many as ten different economic scenarios, all related to changes in interest rates.

In the more than five years that have passed since the financial crisis, America’s largest financial institutions have been under intense legal and regulatory scrutiny. After the financial crisis, politicians and regulators searched for a means to repair the structural problems within the United States and the international banking system in order to insure that a similar financial meltdown would never happen again. Of course, legislation was at the forefront of those efforts. While its effectiveness has been debated, the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July 2010, brought the most significant changes to financial regulation in the United States since the reform that took place following the Great Depression. Chief among its provisions, alongside the so-called “Volcker rule,” which was intended to reduce banks’ ability to take excessive risks, are stress tests.

To assess the health of these companies that brought the American economy to its knees, Congress mandated that the Federal Reserve conduct annual tests to uncover any “risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions.” The approximately thirty-four financial institutions with domestic assets worth more than $50 billion are 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.

Interest rates have increasingly concerned the Fed, as rising rates could prompt banking losses. It is for that reason that the central bank is seeking additional information from banks on how their trading operations would withstand interest rate changes. U.S. short-term interest rates have been held near zero by the Federal Reserve since late 2008 and the central bank has indicated it will continue to do so until the unemployment rate reaches a threshold of 6.5 percent, as long as inflation remains below 2.5 percent.

In fact, the Fed is “in a little bit of a tricky situation,” as RDQ Economics’ Conrad DeQuadros recently told USA Today. The central bank announced that it would begin winding down its extraordinary economic stimulus back in December, lowering its monthly bond purchases by $10 billion in January and February so that current purchases are running at $65 billion. It is widely expected bond purchases will drop to $55 billion after the Fed’s upcoming March Federal Open Market Committee meeting. But while the Fed is likely to proceed with tapering, Fed Chair Janet Yellen will have to explain that interest rates will stay low despite the fact that unemployment has dropped faster than expected. The problem is that the rate of joblessness has fallen to 6.7 percent in recent months partly because many out-of-work Americans have become discouraged and stopped looking for work, which means they are no longer part of the labor force and no longer counted as unemployed. Now, as the Fed has clarified, the benchmark interest rate will stay near zero “well past” the time unemployment hits 6.5 percent. The latest forecast from Fed policymakers showed the first rate increase in late 2015.

But while the Fed will continue to keep the benchmark rate near zero, interest rates are ticking up as tapering continues. With the coming of higher interest rates, the Fed asked banks to test how their trading operations would perform in a mild recession with a 2 percentage point increase in the ten-year interest rate. It was the first time such an economic scenario was included.

Most banks are believed to have told the Fed that higher interest rates would help operations, not cause losses, as Fortune reported. And, higher interest rates can benefit banks because they can then charge more for loans. But it is true when rates rise that banks do tend to lose money on their existing loans and bonds they already own. Eventually, the institution could earn back money lost on those loans and bonds, but the Fed wants to know whether than can survive the initial stress. “In general, the Fed is unhappy with the results of the tests that banks run themselves,” bank consultant Burt Ely told the publication. “The banks do the tests in ways that is favorable to them.” More specifically, the central bank has reportedly become concerned over the fact that many banks are retaining assets — like insurance against mortgage defaults — that would have performed well during the 2008 financial crisis and look good on the tests. Holding on to those assets makes sense; the most dire scenario in the stress test conditions that loosely match the details of the crisis. Still, the Fed believes banks have become overly cautious about protecting themselves against an exact repeat of 2008.

The other major addition to this year’s stress test is a scenario in which an institution loses its largest trading partner to bankruptcy, a situation that mirrors the 2009 bankruptcy of Lehman Brothers, which was followed by the near-collapse of the insurance company American International Group (NYSE:AIG).

On March 20, the Fed will reveal which banks have enough capital to weather a severe economic crisis like the 2008 financial crisis. Then, on March 27, the Fed will announce which banks have been approved to pay dividends or buy back shares in the next few years. As Fortune learned through an executive at one bank involved in the tests, the Fed will be more critical this year. “The Fed’s interest is to see how the banks reveal their own weaknesses,” said the executive. “The Fed keeps raising the bar.”

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