According to a Financial Times report spotted on Tuesday, U.S. banks will have to go through stress tests every year to prove their financial ability to confront another recession. This annual drill is a requirement of the Federal Reserve, which also could hold the right to ban capital deployment activities of unsuccessful banks.
The Federal Reserve Board is ready to approve the rule and seek public opinion on it in a few weeks. Federal Reserve officials came to this conclusion as they are concerned about some banks’ uneconomical returns to their shareholders that make them weak with respect to capital.
Moreover, the Federal Reserve perhaps wants to ensure that banks are more cautious about dividend payments and share buybacks, particularly after they had to shell out billions of dollars as government reimbursement by tapping the capital market.
According to the ruling by the Federal Reserve, if banks want to increase their shareholder returns through dividend hikes, they can resubmit their capital plans in between their annual capital assessments.
According to the Federal Reserve chairman Ben Bernanke, banks needs to establish that their capital plans are sufficient to deal with stress scenarios and meet international capital standards (such as Basel III).
The Story Behind
In January, all 19 banks regulated by the Federal Reserve including Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM), Wells Fargo & Company (WFC), The Goldman Sachs Group Inc. (GS) and U.S. Bancorp (USB), subjected to the first round of stress tests in 2009, had to undergo the second round as well. In the latest round, these banks were required to demonstrate that they have adequate capital to address potential losses over the next two years under various scenarios.
The environment of the latest round of stress tests was dissimilar to the Fed's first round conducted during the middle of the recession to estimate how much banks would lose if the economic downturn proved even deeper than expected. The rerun was, on the other hand, basically a precautionary exercise amid economic recovery.
Also, as the banking industry swung back to profitability in 2010, big banks began pressing regulators to allow them to enhance shareholder value through dividends and buybacks.
Following the release of the second round of stress test results in March, many big banks that were granted the green signal took immediate action to raise their dividends. Also, the Federal Reserve allowed America’s strongest banks that passed the tests to operate independently without strict government restrictions like those imposed during the height of financial crisis in 2008.
The Way to Recovery
Though one may think that restrictions on capital distribution will make the shares of these banks unattractive for investors, the decision to make themundergo stress tests once every year will definitely keep another financial catastrophe away. Surely, after learning a good lesson from the latest recession, Americans will never wish to go back to those dreadful daysonly to earn higher capital rewards from their banks.
Hopefully, disciplined reruns of stress tests will also prevent the big banks from flirting with risky activities that jeopardize economic health. The annual stress tests would also play a major role in abating threats to the economy by forcing banks strengthen their capital levels.
Most importantly, the stress tests could ultimately translate to less involvement of taxpayers’ money for bailing out troubled financial institutions.
BANK OF AMER CP (BAC): Free Stock Analysis Report
GOLDMAN SACHS (GS): Free Stock Analysis Report
JPMORGAN CHASE (JPM): Free Stock Analysis Report
US BANCORP (USB): Free Stock Analysis Report
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