Bank Stress Tests: What do They mean?

Bank Stress Tests: What do They mean?

Blog Date: 3/23/12

Blog Author: Joseph Antony, Business Management Major 


The Federal Reserve conducted a stress test to see if major U.S. banks were adequately equipped in terms of capital to deal with a Depression like economic scenario defined as a 21% drop in housing, 50% decline in stocks, and an unemployment rate of 13%. Banks had to have a minimum 5% Tier 1 common capital ratio in order to pass the test. This was the first stress test conducted by the FED since 2009 in the aftermath of the financial crisis. The results came in on Tuesday, and they are looking good. Eighteen of the nineteen banks which were tested were deemed strong enough to not have a need to raise capital, and 15 of the banks passed the 5% minimum capital ratio test. One noteworthy fact though is that of all the major banks, Citi was only able to score a 4.9% capital ratio which prevented them from raising their dividends to shareholders. Citi, the third largest bank in terms of assets, has shown some vulnerability in contrast to the other major banks such as JP Morgan which has passed their stress test in flying colors. The markets have responded well to this announcement, and coupled with a strong consumer retail report, and a strong report from the FED regarding the economy, many of the indexes had reached multi-year highs on Tuesday.

While many would agree this stress test was a good thing to have conducted, one has to question whether this sort of test is actually effective at preventing future financial calamities such as the one we saw in 2008. In other words, how effective is this stress test at judging a bank’s financial health and how effectively can it judge how a bank will perform in times of turmoil? Some analysts and experts agree while this is a noble gesture, it really doesn’t do much to predict future financial crises. In the end perhaps it is better to have the test than to not have the test but overall this test can only go so far in determining how strong banks really are financially speaking to deal with some sort of future economic catastrophe.