Stressing the Importance of the Fed’s Stress Tests

After the financial crisis of 2008-09, the Federal Reserve isn't leaving anything to chance. U.S. banks with assets of $50 billion or more undergo stress testing each year to assure they comply with regulations and are not at excessive risk in the event of another severe downturn.

Senior banking specialist John Maxfield reviews the most interesting results of the first round of testing, how the market reacted, and which three banks are worth watching as second round results are announced this week.

A full transcript follows the video.

Kristine Harjes: Don't get stressed out! This is Industry Focus.

[INTRO]

Hello everyone, and welcome to the financials episode of Industry Focus. Today we're going to be talking about stress tests on banks, and I have got The Motley Fool's very own senior banking specialist, John Maxfield on the line. Hi, John.

John Maxfield: Good morning, Kristine, how are you doing? I guess it's afternoon for you; you're on the East Coast. I'm on the West Coast. It's still morning over here.

Harjes: Just barely afternoon, but with the time change, who really knows?

Maxfield: Who knows? It could be anything at this point!

Harjes: Yes, we're all sorts of messed up!

Let's dive right into financials. Of course, the big news lately in the banking industry are these stress tests that the Federal Reserve runs annually, in which the 31 biggest banks -- banks that have assets of $50 billion or more -- that are overseen by the Fed go through this testing every year.

The purpose is to determine whether or not these banks have enough capital to survive a hypothetical downturn in the economy. Basically what happens here is that the Fed lays out three scenarios.

They look at a baseline scenario; normal circumstances, economy keeps trucking along normally.

Then you start to get a little bit more negative and you've got your adverse scenario, where the stock market drops a little bit, unemployment rises, etc.

Then, here's when things really get interesting, and what we're truly looking at in these tests; the severely adverse scenario, in which the stock market tanks 60%, unemployment shoots up to 10%, 25% drop in home prices, market volatility's soaring -- all sorts of terrible things going on in the economy. This is the scenario that we're most concerned about, and it's the true point of these tests.

In each of these scenarios, the banks are given the opportunity to submit complex plans outlining what happens, hypothetically, in each of these scenarios to their businesses and their capital ratios.

John, I'm going to let you take a deeper dive here. Before we discuss the actual results from this first round of testing that happened, why are these results and these tests so important? What is the risk that they're designed to reduce?

Maxfield: There are a couple of different ways to answer that. From the societal standpoint, the reason that these stress tests are important is, if you go back to the crisis of 2008 and into 2009, one thing that was saw was that banks had all these investments in various types of securities and derivatives that were tied to subprime mortgages and when those mortgages took a hit, that reduced their capital levels.

I think it's probably fair to say, almost across the board at almost every bank in the country, it pushed them into the accounting equivalent of insolvency, because these credit markets froze up, which caused the asset values on their balance sheets to drop precipitously.

When you consider that banks are leveraged, on average, 10:1, it only took a 10% drop in assets to completely wipe out the capital base of these banks.

The purpose of the stress test is to proactively get in front of a crisis like that, to make sure that the banks are positioned, both on the asset side and on the liability side, to be prepared for, in the words of the Federal Reserve, "a severely adverse economic crisis" akin to the financial crisis of 2008-09.

That's the reason it's important from a societal standpoint, because it presumably will help stop us, as taxpayers, having to step in to bail out banks if they get into trouble again.

From the perspective of an investor, why this really matters at this point, now that we're five-six years out of the crisis, is that the Federal Reserve, as a result of Dodd-Frank and a whole bunch of regulations that were passed pursuant to Dodd-Frank in the aftermath of the crisis, the Federal Reserve now has the right to either approve or reject capital plans of all the nation's biggest banks.

Let's take Citigroup (C 1.41%) as an example, because they were rejected last year. Citigroup hasn't raised its dividend since the financial crisis. It's one of the few banks that hasn't, and the reason it hasn't is because the Federal Reserve won't allow it to, because it has performed so poorly on the stress tests in the past. That's the reason that it matters for investors.

Harjes: Absolutely, and with Citigroup of course this is something to really keep an eye on regarding these tests, because Citigroup has not done too well on these tests so far. In fact, we're potentially looking at the CEO stepping down, if Citigroup were to not do well this year.

Of course, that alludes to the issue that we don't just have the tests that we have the results for from last week, but we also have this new round of tests that is coming out this following Wednesday. Do you want to discuss a little bit what the difference in the two rounds are?

Maxfield: Yes. The first round, you explained this at the outset. The Fed makes a number of projections about what's going to happen to the economy over basically a two-year stretch. There are different layers to those. There's a baseline, there's an adverse, and there's a severely adverse.

Then the Fed is just looking to see what happens to the capital ratios at these banks under those hypothetical scenarios. That's assuming that the capital plans that are in play at these banks presently, stay in play for that two-year time period.

This next step -- and these are the results that are due out on Wednesday, March 11 -- the banks will go through and they will ask the Federal Reserve to either increase their dividends or increase the amount of share buybacks they're doing over the next year. They'll ask for permission to do that.

The Fed will then take those proposals and factor those into the results of last week's stress test, to see what that additional release of capital to shareholders will do to the bank balance sheets, to see if that will then dip them below those regulatory minimum thresholds for the capital ratios.

If it does dip them below that, then those capital plans will either be outright rejected, or the banks will be given an opportunity to submit revised requests for capital. That's how those two steps play together.

Harjes: That second round of results is really what investors are going to be looking at, but right now what we have to go off of and discuss is just round one.

Assuming that the dividends and capital allocation plans remain the same as they are currently, we found out that all 31 of the banks that were tested, passed the stress test, which of course means that even in a scenario of a sharp economic downturn, as we've said, that the capital levels didn't drop below the regulatory minimums.

The results reported that cumulative Tier 1 common capital ratio was projected to fall, in said hypothetical severely adverse scenario, from the current 11.9% to a minimum level of 8.2%. Just to add some context, at the peak of the last crisis, this figure bottomed out at 5.5%, so that's looking like these banks are positioned pretty well.

Was there any particular bank that you think performed worse than you would have expected?

Maxfield: The one bank that surprised everybody, I would say, was Goldman Sachs (GS 1.79%). Keep in mind that Goldman Sachs is not your traditional bank. They don't have branches out there where you and I are going to deposit money, and then we're getting loans to buy a home.

They're traditionally an investment bank, but they switched over to a bank holding company during the financial crisis so they could have access to a number of different things that would keep them alive, that the Federal Reserve provided to traditional banks.

Goldman Sachs is an exceptionally run organization, regardless of how you look at it, but when you look at one of those capital ratios -- I think it was the total risk based capital ratio -- it came, in the hypothetical severely adverse economic scenario, at the nadir of this hypothetical crisis, Goldman Sachs' total risk based capital ratio I think fell to 8.1%.

The regulatory minimum for that is 8%, so that really leaves very little additional capital that then Goldman can, under this next round of stress testing, ask the Federal Reserve to distribute to its shareholders.

The big question is, will Goldman Sachs be able to increase its dividend this year, or will it not be able to, given those results?

Harjes: How have share prices been affected so far?

Maxfield: That's actually a really good question. I can talk to just a couple banks in particular.

Citigroup, which is surprising because it actually did really, really well in this year's stress test if you're just looking at the actual numbers, it came out with an unusually high Tier 1 common capital ratio, even at the nadir of the hypothetical financial crisis.

But after the results were released its shares actually went down a little bit, which would seem to suggest that the market was, to a certain extent, expecting it to do a lot better this year than it did last year.

Now on the other hand, Bank of America (BAC -0.21%), which didn't do as well as Citigroup did on the stress test, on a relative basis, its share price went up about 2.5% the day after the results were released.

Just in general, it's a mixed bag.

Harjes: Super interesting. Do you think that investors should be placing much weight on the outcome of this first round of tests? To what extent can you predict the result of the test that we'll see on Wednesday, at this point?

Maxfield: That's a great question. I think that investors should care about the tests because the tests dictate whether or not these banks will be able to increase the amount of capital they return to shareholders, and the extent of that increase. That's why investors should care.

Now, I would say that investors shouldn't look at these stress tests as a guarantee that if the economy were to go through a similar situation, that how those projections turn out is exactly how these banks would perform in the next crisis.

There are so many different moving pieces in the economy that when the economy goes south and you have banks failing, you have counterparties failing, you have all these different things going on, it is impossible to predict exactly what that looks like.

In terms of just using the stress test results as a gauge of safety and security, yes it may be a proxy for that, but ... not to use a cliché, but the proof is in the pudding. You never know exactly what the next crisis is going to look like until you're in the midst of it. At that point, that's the only way you'll know what's going to happen to those capital ratios.

Harjes: Makes sense. To wrap up a little bit, what three banks are you going to be watching with the most interest, come Wednesday?

Maxfield: Unquestionably Citigroup, because Citigroup has been rejected two years in a row for a proposed dividend increase, and they are the one big bank that has not been able to increase their dividend since the financial crisis, so that's number one.

Number two is Goldman Sachs, for the reason I discussed earlier. Their performance on the total risk based capital ratio, is that going to impede their ability to increase the amount of capital they return to shareholders?

Then last but not least, if I had to pick just one in addition to those ... let's pick a healthy bank. I would say look at Wells Fargo (WFC -0.03%). Wells Fargo has a history of returning a lot of capital to shareholders.

They've performed well on every stress test in the past, their earnings are spectacular, they've done well through multiple cycles in the past, so it'll be interesting to see how far up they take that dividend payout ratio relative to what they've done in the past, because it will give us an idea of how much capital the Fed is going to allow even the best-run banks to start distributing to its shareholders.

Harjes: Great picks. Investors and taxpayers, be sure to keep an eye out for round two stress test results that are coming out this Wednesday. The results are sure to paint a picture of what we can expect in the coming year across the banking industry, as well as shed a little bit of light on the potential repercussions of a financial downturn, which is something that should interest all of us.

John, thanks for your time today, as always, and for all of the great information you brought to the table. Folks, be sure to check back to Fool.com for more banking and financial analysis, as well as for all your investing needs -- and don't stress too much. Fool on!

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.