This is an important week for the nation's biggest banks. On Thursday, the Federal Reserve will report the results for the 2017 Dodd-Frank Act stress tests, or DFAST. It will follow that up on June 28 by releasing the results of the comprehensive capital analysis and review, or CCAR.
While Bank of America (BAC 3.35%) has intermittently run into troubles on the stress tests in the past, there's every reason to believe that it will sail through the process this year.
Tests can be stressful. Image source: Getty Images.
The purpose of the first round of the tests, DFAST, is to assess whether banks have enough capital to continue lending to households and businesses even in a serious recession. The Fed tests this by making a number of economic assumptions and then estimating what would happen to a bank's balance sheet under the hypothetical scenario.
The assumptions are extreme. For the 2017 cycle, the most severe scenario presupposes, among other things, a global recession in which the U.S. unemployment rate rises to 10%. That's in line with the financial crisis of 2008 and is more than twice today's figure.
To give you a sense for the impact on a bank's balance sheet, in last year's test, the Fed estimated that Bank of America would incur $59 billion in loan-loss provisions, $20 billion in trading and counterparty losses, and roughly $3 billion in miscellaneous losses. All told, after factoring in revenue, the Fed estimated that the Charlotte, North Carolina-based bank would incur $36 billion in bottom-line losses over the test's nine-quarter horizon.
That's a lot of money, but Bank of America nevertheless still sailed through last year's DFAST with more than enough capital. It's common equity tier 1 capital ratio bottomed out at 8.1% in the severely adverse economy scenario. That was down from 11.6% entering the projected downturn, but it was still well above the 4.5% regulatory minimum.
Data source: Bank of America. Chart by author.
It's for this reason that investors in Bank of America can be confident that the nation's second-biggest bank by assets will once again sail through DFAST. In the intervening year, Bank of America's CET1 ratio has climbed to 12%, up 40 basis points from the same time last year. This gives the bank even more cushion to absorb losses in a severe downturn without interfering with its ability to continue lending.
On top of this, Bank of America's earnings have improved consistently after the bank turned the corner two years ago from the financial crisis. Its net income applicable to common stockholders in the first quarter of the year was $4.4 billion, up from $3 billion in the year-ago quarter. Like capital, higher earnings give a bank more cushion to absorb losses without having to stop making loans.
And it's worth pointing out that Bank of America almost certainly becomes more comfortable and confident with the stress tests with each passing year. This offers no guarantee, as the Fed's analytical models used to test banks are notoriously nontransparent. But it certainly leans in favor of the assumption that Bank of America won't stumble in this year's test.
