Here’s Why JPMorgan Chase Will Easily Pass This Year’s Stress Tests

The stress test is no longer stressful for JPMorgan Chase (JPM 1.44%). As such, investors in the nation's biggest bank by assets can confidently expect it to sail through the Dodd-Frank Act stress tests, or DFAST, the results of which are due out tomorrow.

The purpose of DFAST is to determine whether the 34 banks in the United States with more than $50 billion in assets have enough capital to survive an economic downturn akin to the financial crisis. If they do, then they pass. If they don't, then they fail.

Jamie Dimon, the Chairman and CEO of JPMorgan Chase. Image source: JPMorgan Chase.

To determine this, the Federal Reserve makes a number of economic and financial assumptions, and then tests to see how a bank's earnings, balance sheet, and regulatory capital ratios would hold up if all of the assumptions were to strike at one time, as they did in 2008.

In this year's test, the Fed assumes that the unemployment rate spikes to 10%, gross domestic product drops by 6.5%, stock prices lose half their value, home prices drop by 25%, and commercial real estate prices fall 35%, among other assumptions.

The principal metric that the Fed uses to determine whether a bank has enough capital to survive and continue lending in the face of these assumptions is the common equity tier 1 capital ratio, or CET1. This compares how much highly liquid capital a bank has relative to a risk-weighted measure of assets. The rules underlying these calculations are complicated, but it's the output we're interested in.

To pass the test, a bank must maintain a CET1 ratio of at least 4.5%. That's the controlling threshold that matters. If one were to keep their eye on the prize, in other words, this is it.

Going into this year's test, JPMorgan Chase's CET1 ratio was 12.5%. I won't belabor you with the math, but this means that JPMorgan Chase has $118 billion in excess capital above the 4.5% regulatory minimum.

Source: JPMorgan Chase, author's calculations.

That's a lot of money. And it's significantly more than JPMorgan Chase was projected to lose in last year's test, when the Fed estimated that the New York-based bank's net loss through the test's nine-quarter time horizon would add up to $30.5 billion.

Assuming JPMorgan Chase loses a similar amount in this year's test, in turn, it would still have $88 billion in excess common equity tier 1 capital above the 4.5% benchmark that's needed to pass the test. That's a humongous cushion that, absent a global cataclysm that snuck into the stress-test assumptions without anybody knowing about it, essentially ensures that JPMorgan Chase will sail through this year's test.