The Federal Reserve just announced the results of this year's banking stress tests, and the tests found that all of the banks examined would survive in a severe global recession. Here's a rundown of which banks are affected by the stress tests, what exactly they're "testing" for, and why the most important part for shareholders is still to come.

The stress tests don't apply to all banks

The Federal Reserve's stress tests don't apply to all banks that do business in the U.S. In fact, they apply to even fewer banks this year than they did previously.

Bank sign on exterior of a building.

Image Source: Getty Images.

The stress tests are designed to prevent banks that are "too big to fail" from requiring government bailouts during economic downturns. The technical term for these banks is Systemically Important Financial Institutions, or SIFIs.

Since the Dodd-Frank banking reforms were implemented, the SIFI threshold has been defined as banks with $50 billion or more in total assets. However, a recent rollback of the SIFI rules will gradually raise this threshold to $250 billion.

For the 2018 stress tests, an asset threshold of $100 billion applied. So, of the 38 banks that were examined, three became exempt because of the new law. In other words, the stress tests only applied to the 35 largest banks in the U.S. market.

What are the stress tests, exactly?

In a nutshell, the Federal Reserve stress tests are designed to determine how the largest U.S. banks would fare in a severe global recession.

Specifically, the 2018 stress test used the following "severely adverse" scenario:

  • Negative 7.5% GDP growth over seven quarters
  • 10% unemployment by the third quarter of 2019
  • 65% drop in equity prices by early 2019
  • The VIX volatility index moves above 60
  • 30% drop in housing prices
  • 40% drop in commercial real estate prices
  • A sharp global downturn, including severe recessions in the U.K., most of Europe, and Japan.

The 35 banks that were subject to the stress tests this year would lose a total of $578 billion over nine quarters under this hypothetical scenario. Two things to remember: First, this is essentially a worst-case scenario, and any actual recession is unlikely to be nearly this bad. Second, all 35 of the banks would be able to survive such a scenario and without government bailouts or other outside help.

The important part for investors comes next week

From an investor's perspective, the most important reason for the stress tests is to determine if each bank is adequately capitalized to pay dividends and buy back shares. For these 35 banks, the Federal Reserve will have to approve their capital plans for the coming year. Unfortunately, we'll have to wait until next week to find out whether the banks have Fed approval, as well as to see how much each bank plans to pay in dividends and how much they plan to use to buy back shares.

Since the end of the financial crisis and the implementation of the stress tests, two clear trends have emerged.

First, banks are generally building their dividends back up, as you can see in the chart below.

BAC Dividend Chart

BAC Dividend data by YCharts.

Second, most of the big banks are choosing to emphasize buybacks over dividends, and I don't expect that to change anytime soon. For example, in 2017, Bank of America returned $16.8 billion to shareholders, but $12.8 billion (76%) of this amount was in the form of share buybacks. Banks have generally felt that their shares have been undervalued in recent years, plus it's less harmful to a stock to modify a buyback program than it is to slash a dividend in case the company's profits fall. So, in a nutshell, banks are emphasizing large buybacks and easily sustainable dividends, and when the capital plans are revealed next week, I'd expect this trend to continue.

Matthew Frankel owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.