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Everything You Need to Know About the Stress Tests

Major U.S. banks could lose $194 billion in an adverse economic scenario. But this time, it appears, they'd be ready to handle that walloping.

For the first time, the Federal Reserve ran through the Dodd-Frank-mandated banking stress tests. That made what was a one-step stress-test process last year -- the Fed's Comprehensive Capital Analysis and Review -- a two-step process this year. 

Both tests examine how bank balance sheets would hold up under the pressure of an extremely adverse economic scenario -- a scenario that this year included a severe recession in the U.S. combined with a housing market drop, rising unemployment, a global financial shock, and marked slowdowns in the eurozone, Japan, and the developing Asian countries. But while the CCAR looks at banks' capital plans -- which may include, for instance, raising dividends -- the Dodd-Frank tests assume consistent capital plans.

Ally Financial -- the former GMAC -- managed to fail the Dodd-Frank test pretty seriously. But it was alone in that feat. All of the other 17 banks tested had minimum stressed capital ratios that were comfortably above required minimums.

Of particular focus in these tests is the Tier 1 common ratio. The mandated minimum level by regulators -- which we could reasonably call the pass/fail line in these tests -- is 5%.

Some of the banks like Bank of New York Mellon  (NYSE: BK  ) and State Street, which are primarily banks for banks and maintain solid, low-risk balance sheets, breezed through the tests. Others, like Goldman Sachs  (NYSE: GS  ) and Morgan Stanley cut it a bit closer thanks to their trading portfolios and the hits they were expected to take in the hypothetical global financial shock.

Big banks Bank of America  (NYSE: BAC  ) and Citigroup  (NYSE: C  ) were probably the most watched -- and certainly the most talked about -- coming into the tests. Both banks passed the tests easily, though if one stood out as a particular surprise, it was Citi and its strong showing. Bank of America, meanwhile, though improving on its CCAR showing from last year, was perhaps more of a disappointment (particularly if you ask this Fool).

But investors in the individual banks will certainly want to get beyond the aggregates and take a closer look at the bank-by-bank results. To help with that, we've put together a cheat sheet for each bank that will help you get up to speed quickly on how each bank fared through the first round of stress testing.

Click on the name of the company to see the full breakdown:

The Big Four Regional Banks Others
Bank of America BB&T  American Express 
Citigroup Fifth Third  Bank of New York Mellon 
JPMorgan Chase KeyCorp  Capital One  
Wells Fargo (NYSE: WFC  )   PNC Financial Goldman Sachs 
  Regions Financial   Morgan Stanley 
  SunTrust  State Street 
  U.S. Bancorp   

In the end, if there's one key takeaway from the first round of stress tests, it's that the results suggest that the country's major banks could rack up close to $200 billion in losses and still maintain a median 7.7% tier 1 common ratio. That's a huge change from just a few years ago -- and a big relief. 

Some readers may scoff at the tests and how much comfort they can give us. After all, what if the next shock-and-awe financial meltdown doesn't look like the one that the Fed has created here? While that's a reasonable view, it misses the bigger picture. Banks were able to come out the other side of these tests looking good largely because they simply have a lot more capital than they did in 2007. 

A wooden house may fold under hurricane conditions, but if you bolster those walls with a brick backing, it can withstand a lot more. There's little doubt in my mind that bank balance sheets are in a very good place right now. If there's something to be worried about, it's not in the here and now. Instead, it's whether the banks will keep up that level of safety, or shuck it down the road for a shot at a fatter bottom line.

One big stress-test winner
Citigroup stood out as a big upside surprise in the first round of stress tests. Does that mean that investors should be jumping on an opportunity to buy? To help figure out whether Citigroup deserves a spot on your watchlist, I invite you to read our premium research report on the bank today. We'll fill you in on both reasons to buy and reasons to sell Citigroup, and what areas that Citigroup investors need to watch going forward. Click here now for instant access to our best expert's take on Citigroup.

Read/Post Comments (3) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 11, 2013, at 9:09 PM, AnneElk wrote:

    I'm sorry, but after living through it (and reading several books by people directly involved in the decisions/actions made), I have trouble placing much stock in a "Stress Test" performed by the Fed.

    I believe these to be pretty much propaganda issued to placate the masses.

  • Report this Comment On March 11, 2013, at 9:19 PM, rdub76 wrote:

    The only criteria needed by a bank to meet the fed's stress test is access to the fed's discount window. I have always loved that term: Discount Window. It makes the lender of last resort sound like a fast food drive through... which coincidentally is what it has become.

  • Report this Comment On March 16, 2013, at 5:49 PM, jd8019 wrote:

    What about the small and medium sized banks? What happens if they don't have enough capital on hand? If a lot of them fail, won't it also affect the rest of the banking industry? They aren't held to the same standards, so what happens to the big banks if they fail?

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