Here's How Morgan Stanley Fared in the Stress Tests

Yesterday, the release of the results from the Federal Reserve's annual stress tests highlighted the impact of the changing regulatory and operating environment on firms like Morgan Stanley (MS 0.10%) and Goldman Sachs.

While these capital markets-focused firms undergo the same assessments as the large depository institutions with trading arms like JPMorgan Chase and Bank of America, the instability of the business segments that rely on the activity of institutional clients results in more volatile capital ratios during turbulent times.

Despite a slightly tarnished reputation and sharp decline in its trading business year over year, Morgan Stanley entered this year's stress tests with an even stronger capital position compared to last year. The investment bank increased its Q3 Tier 1 common ratio 190 basis to 13.9% in the 2012.

Although posting strong actual ratios is favorable, the main purpose of the Fed's stress tests is to examine the how these institutions would fare if the domestic and global economy experienced another crisis similar to what happened in 2008. In the "severely adverse" economic scenario, which included a sharp contraction in Europe and developing Asian market, Morgan Stanley's Tier 1 common ratio crippled to 5.7%, only 30 basis points better than last year's tests.

Sources: Dodd-Frank Act Stress Test 2013: Supervisory Stress Test Methodology and Results. Comprehensive Capital Analysis and Review 2012

The six bank holding companies with significant trading operations, including Morgan Stanley, were subject to scenarios that exposed additional counterparty risk and markdowns on assets. While this additional stressor negatively impacts the behemoths with trading arms like JPMorgan Chase and Bank of America, the firms without large consumer bases are likely to feel this impact to a greater extent. The Fed's doomsday scenario projected Morgan Stanley's performance over a nine-quarter period with a total loss of almost $20 billion under the severely adverse conditions.

Source: Dodd-Frank Act Stress Test 2013: Supervisory Stress Test Methodology and Results.

Despite the drastic deterioration of capital levels in the Fed's harshest scenario, investors should note that although Morgan Stanley posted similarly depressed capital levels last year, the stock still beat the return of the S&P 500 since the release of the previous stress tests.

Next Thursday, the Fed will release Comprehensive Capital Analysis and Review (CCAR) results which will look very similar to these results but will take into consideration any potential proposed increases in dividends or share repurchases. Last year, Morgan Stanley did not request to increase its dividend, and given the performance of its market-based businesses in 2012 and stress test results, shareholders may not be expecting this year to be any different.