B of A Will Pass the Stress Test With Flying Colors

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This is a big week for banks. On Thursday, the Federal Reserve releases the results of the annual stress tests, which ultimately dictate whether or not the nation's largest financial institutions can increase the amount of capital they return to shareholders via dividends and/or share buybacks.

While the term has become a bit of a misnomer, as there's no question that most banks will pass at least the first round of examinations -- the second round comes next week when the Fed considers capital allocation requests -- it's still a critical stage in the annual rhythm of banks. And none more so than Bank of America (NYSE: BAC  ) .

To get to the point, I believe B of A will not only pass this round of tests, but that it will do so with flying colors. And while that may not surprise you, the reason it will pass so comfortably suggests to me that the nation's second largest lender will also be given approval next week to increase its quarterly dividend payout.

A brief introduction to stress tests
In the wake of the financial crisis, Congress enacted the Dodd-Frank Act, which requires the Federal Reserve to conduct stress tests of banks and other financial concerns with assets in excess of $50 billion. The purpose is to evaluate whether these so-called too-big-to-fail institutions have, as the Fed describes it, "sufficient capital, on a total consolidated basis, to absorb losses as a result of adverse economic conditions."

The process seeks to simulate the impact on a bank's regulatory capital levels under three hypothetical and increasingly severe economic scenarios. The most arduous assumes that real GDP declines an average of 4% this year, the unemployment rate ticks up to 12.1% in the second quarter of next year, and that home prices fall by more than 20% by the end of 2014. Suffice it to say, this is an extreme case. As the Fed notes, at least with respect to unemployment, the designated rate remains "above any level experienced over the last 70 years" -- that is, since the Great Depression.

Facing an analogous scenario last year, B of A passed with a comfortable if not excessive margin of safety. The Fed's stressed capital projections for the bank estimated a minimum Basel 1 Tier 1 common capital ratio of 5.7% under the most severe adverse economic conditions, exceeding the requisite 5% rate. Nevertheless, as you can see here, that put B of A near the bottom of its peer group, beat out by the likes of Citigroup (NYSE: C  ) , Wells Fargo (NYSE: WFC  ) , and JPMorgan Chase (NYSE: JPM  ) , among others.

The good news is that the tides have since turned, as it's likely that B of A will come out much closer to the top of the list this year. Among other accomplishments, it's now the best capitalized of the four megabanks, with a Tier 1 common capital ratio under the more stringent and yet to be implemented Basel III standards of 9.25% -- JPMorgan and Citigroup's come in at 8.7%, and Wells Fargo's at 8.2%. Additionally, as you can see below, it's dramatically improved its Basel I capital base on an absolute level as well.

Source: Bank of America's 3Q12 10-Q and 2012 10-K.

What this chart shows us is that B of A had far more excess capital at the end of the third quarter last year (i.e., the numbers that were submitted for this year's stress test) than it did at the same time in 2011. To point out only the most significant, it grew its excess Basel I Tier 1 common capital by a staggering $27 billion, from 8.65% of risk-weighted assets all the way up to 11.41%. In addition, and equally notable, the bank reduced its risk-weighted assets across the board, as evidenced by the declines in mandatory capital levels illustrated by the darker portions of the chart above. To say that this has been an accomplishment doesn't do it justice.

At the end of the day, of course, anything can happen. But given the dramatic increase in capital beyond regulatory requirements -- that is, the very thing the stress tests measure -- I believe it's safe to say that the likelihood B of A will fail on Thursday is slim to none. The more interesting question, in turn, is whether it will be given the go-ahead to up its dividend payout. For the answer to that, however, we'll have to wait until next week.

Want to learn more about B of A?
Bank of America's stock doubled in 2012. Is there more yet to come? With significant challenges still ahead, it's critical to have a solid understanding of this megabank before adding it to your portfolio. In The Motley Fool's premium research report on B of A, analysts Anand Chokkavelu, CFA, and Matt Koppenheffer, Financials bureau chief, lift the veil on the bank's operations, including detailing three reasons to buy and three reasons to sell. Click here now to claim your copy.

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