This past week was one of the most consequential for banks. It was the week they faced the Federal Reserve's stress tests.
Despite all the attention paid to the annual exercise, however, there was little doubt that most banks would pass it, including Bank of America (BAC 1.59%), the nation's second-biggest bank by assets.
The results that were released last week correspond to only the first of two rounds of stress test results -- the second will be published next week. The purpose of the first round is to ascertain whether banks with more than $50 billion in assets on their balance sheets have enough capital to survive a severe economic downturn akin to the financial crisis.
The threshold that regulators use to determine this is the common equity tier 1 common capital ratio, or CET1 ratio. This measure how much high-quality, highly liquid capital a bank has relative to a risk-weighted measure of its assets. To pass the test, a bank must maintain a ratio of 4.5% through a hypothetical gauntlet that assumes that the unemployment rate more than doubles to 10%, that stocks lose 50% of their value, and that residential and commercial real estate prices suffer substantial declines, among other things.
Going into the stress tests, Bank of America's CET1 ratio was 12.1%. There's no reason to get bogged down in the math, but this meant that the Charlotte, North Carolina-based bank had $169 billion worth of CET1 capital. To meet the 4.5% threshold, it would need $63 billion in high-quality capital.
According to the Fed's estimates, Bank of America would record a $26.4 billion net loss through a severely adverse economic downturn. This would leave it with a CET1 ratio of 8.9%, which is nearly twice what the central bank thinks Bank of America would need to not only survive such an event but to be able to continue lending through it.
Given this sizable margin for error, there was little doubt that Bank of America would pass the first round of the stress test. The question now is whether it will have the same experience on the second round, the results of which are due out on Wednesday of the upcoming week.
The second round is especially important because that's when banks learn whether they can increase their dividends and the pace at which they buy back stock. To determine this, the Fed looks at the results from the first round of the stress tests, as well as the impact that a bank's proposed capital plans would alter them going forward, as distributing capital to shareholders reduces a bank's CET1 ratio.
But even though this adds another variable to the equation, there's little doubt that Bank of America would be able to maintain the requisite 4.5% CET1 ratio, given the extent of its excess capital. It's for this reason that shareholders in Bank of America are safe to assume that it will not only pass both components of this year's stress tests, but that it will also be given the go-ahead to increase the amount of capital it returns to shareholders over the next 12 months.
