The annual stress tests administered by the Federal Reserve have become something investors and analysts watch closely. But this could soon change, as most of the 34 banks subjected to the test have far more capital than needed to pass it. Wells Fargo (WFC +1.70%) offers a case in point.
The stress tests were enacted in response to the financial crisis, mandated by the Dodd-Frank Act of 2010. The purpose of the exercise, referred to as DFAST, is to estimate whether banks with more than $50 billion in assets have enough capital to survive an economic downturn akin to the 2008 crisis. The Fed will publish these results tomorrow.
The Wells Fargo stage coach. Image source: Wells Fargo.
The Fed conducts the test by making a number of economic and financial assumptions, and then projecting what would happen to a bank's earnings, balance sheet, and regulatory capital over a nine-quarter time horizon in light of them. In this year's test, for instance, the Fed assumes that the unemployment rate spikes to 10%, gross domestic product contracts by 6.5%, stock prices lose half their value, home prices drop by 25%, and commercial real estate prices fall 35%.
Whether a bank has enough capital to survive this is determined by looking at the common equity tier 1 capital ratio, or CET1. This compares how much high-quality, highly liquid capital a bank has as a percentage of its assets -- or, more precisely, as a percent of a risk-weighted measure of the bank's assets. So long as a bank is able to maintain a 4.5% CET1 ratio, then it passes DFAST.
Going into this year's test, Wells Fargo's CET1 ratio was 11.5%. I won't belabor you with the math, but this means Wells Fargo has $91 billion in excess capital above the 4.5% regulatory minimum.
|
Wells Fargo Capital Metric |
Amount (millions) |
|---|---|
|
CET1 Capital |
$149,860 |
|
Cushion over regulatory minimum |
$91,327 |
|
Estimated loss in 2016 DFAST |
$25,200 |
|
Excess CET1 capital over regulatory minimum and estimated loss in 2016 DFAST |
$66,127 |
Data sources: Wells Fargo, author's calculations.
That's a lot of money. And it's significantly more than Wells Fargo was projected to lose in last year's test, when the Fed estimated that the California-based bank's net loss over the nine-quarter horizon would add up to $25.2 billion.
Assuming Wells Fargo loses a similar amount in this year's test, then, it would still have $66 billion in excess common equity tier 1 capital above the 4.5% benchmark that's needed to pass the test. That's a substantial cushion that, absent a completely unforeseen event, all but guarantees Wells Fargo will sail through this year's test.
