As part of the Dodd-Frank financial reforms in the aftermath of the 2008 financial crisis, the largest banking institutions in the United States are subject to annual stress tests. Not only do these tests measure how a bank would fare in a hypothetical downturn, but they also determine how much each bank can spend on dividends and buybacks over the next 12 months.

In this episode of Industry Focus: Financials, host Shannon Jones and Fool.com contributor Matthew Frankel give a rundown of what investors need to know about this year's bank stress tests.

A full transcript follows the video.

This video was recorded on July 2, 2018.

Shannon Jones: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, July 2nd, and today, we're talking about Fed financial report cards -- more specifically, how the nation's largest banks fared with the latest round of stress test, what that means for their capital allocation plans, and ultimately, what that means for you as an investor. I'm your host, Shannon Jones, and I'm joined via Skype by financial specialist/ guru, Matt Frankel. Matt, so great to be here with you on the show today!

Matt Frankel: Always good to be here!

Jones: Awesome! Before we dive into the actual results of the stress tests, let's just set the stage. Let's talk about, what exactly is a stress test, and more importantly, why is it even done in the first place?

Frankel: First, the important thing is who this actually applies to. This only applies to the biggest banks in the U.S. If you see your local credit union or regional bank, chances are they're not subject to the stress tests. These are part of the Dodd-Frank financial reforms that were enacted after the financial crisis. They're basically designed to ensure that the banks that are too big to fail aren't in a position where they could fail. 

Basically, it established the definition of what we refer to as a SIFI, which stands for systemically important financial institution. These are the biggest banks in the country. The threshold for years has been set at $50 billion in total assets. The recent banking regulation rollbacks that we referred to in the previous episode raised that to $100 billion this year, and it's going to gradually increase until it gets to $250 billion. This is going to increasingly apply to even bigger and bigger financial institutions only. This year, there were 35 banks in all that it applied to.

So, what is the stress test? Basically, the stress test sees what would happen to a bank in a worst-case scenario, a severe global recession. These are hypothetical tests designed to see what would happen if the economy got really, really bad. To give you the statistics of what they're looking at this year, the hypothetical scenario is negative 7.5% GDP growth, 10% unemployment, 65% crash in the stock market, 30% drop in housing prices, and a few other factors. Just to put that in perspective, the financial crisis in 2008 led to the Great Recession, where we saw GDP contraction of about 3.5%. Unemployment did get to 10%. The stock market, from peak to bottom, fell about 57%. In other words, this is a scenario that's even worse than the Great Recession, a really bad scenario. They want to make sure that banks have enough capital to make it through a situation like that.

Jones: Absolutely. The overarching goal of these stress tests is really to ensure that we never get to that place again. When we're looking at the specific financial metrics that the Feds actually reviewed for these banks, Matt, what were they looking at? And, overall for the industry, how exactly did the industry fare?

Frankel: They're looking at four specific capital levels. Without giving you too much of a lesson behind them, they're known as the tier one leverage ratio, common equity tier one ratio, the tier one capital ratio, and the total capital ratio. Depending on which metric you're talking about, you want the number to be somewhere between 4-8%. 8% is the total capital level, which is the big picture. The other definitions have been phased in over the Dodd-Frank reforms coming in to be.

Anyway, long story short, this year, all 35 banks passed the initial stress test, which makes sure that they will have sufficient capital in a severe global recession. This test found that, between all 35 of them, they would lose a total of $578 billion over a nine-quarter recession, which is a lot of money, but it's not enough to put any of them out of business, is the key takeaway here. So, things will get bad, but the banking system would not need a bailout like it did ten years ago.

Jones: Exactly. Key takeaway is, long story short, with all 35 banks passing, this is really good news for the industry and for the economy as a whole. As a matter of fact, the Vice Chairman of the Federal Reserve even went on to say that the capital levels of the firms after this hypothetical severe global recession are actually higher now than what they were looking back pre-recession years. What we have right now is a pretty impressive growth and management of our largest banks. It really speaks to how well-capitalized they are for the future compared to where they were.

With that, Matt, let's talk a little bit about what this means. Why does it even matter for investors?

Frankel: First of all, it's interesting to note that this year's scenario that was tested -- I mentioned the 65% drop in the stock market, and things like that -- was actually worse than it had been in previous years. In other words, the test is getting harder, and all 35 still passed. 

What this means for investors, obviously it's a good thing. If the economy was on the verge of collapse again, the banking system would make it. That's definitely good for bank investors. We want to know that they won't need a bailout attached to their money again, which was a big problem. 

The second phase of the stress test is to approve the bank's capital plan for the next 12 months. This means how much they're allowed to pay out in dividends, and how much they're allowed to use to buy back stock. This is just for the largest of the large financial institutions. 18 of those 35 banks had to have their capital plans reviewed this year. The Fed wants to know that, even if things went terribly, if the bank wants to spend this much on dividends and this much on buybacks, it would still have a nice cushion if things went poorly.

Jones: Exactly. And not only that. We had, for the first part of the stress test, all 35 banks were able to pass that with pretty flying colors. It was the second part of the stress test that some banks actually stumbled. Let's talk a little bit about, what were some of the biggest surprises that came out of that?

Frankel: Out of the 18 that were subject to having their capital plans reviewed, 15 got the green light. There were a few that were not doing so well. Deutsche Bank (NYSE:DB), this is their U.S. division, was the only one that had their capital plan outright rejected, meaning that they have to come back and resubmit it within a few months. The two big investment banks -- Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) -- were conditionally approved. I wrote an article on this, you guys can read it if you'd like to. The big effect of this is that Goldman Sachs and Morgan Stanley can't increase their capital spending this year on dividends and buybacks.

The reason for this, to make a long story short, is tax reform really killed them this year, for different reasons. Goldman Sachs had to deal with the repatriation of foreign profits. That was a change this year. Morgan Stanley had a big deferred tax asset on its balance sheet that became less valuable when the corporate tax rate dropped. 

But, those two banks barely made it, capital-wise. They were much closer to the threshold than some of the other big banks. So, the Fed is hesitant to let them spend even more money on buybacks and dividends. They both submitted a revised version of what they wanted to do, and it consisted of keeping their capital levels constant this year. That got approved by the Fed.

As far as positive surprises go, Wells Fargo (NYSE:WFC) was probably the biggest positive surprise. I probably don't have to tell most listeners, Wells Fargo hasn't had the best couple of years, when it comes to their fake accounts scandal, the fallout from that, the other mini scandals along the way, and just recently, their punishment by the same Federal Reserve that says they're not allowed to grow until they improve. They actually got the approval to buy back more than twice the amount of stock that they did last year. One, that says a lot about how well-capitalized they are. Two, it also says a lot that their management's willing to do that, that they think that their stock is at such a compelling bargain right now that they're willing to spend over $25 billion on buybacks alone.

So, we had some winners, we had some negative surprises. But, in general, the capital plans were approved. Most of the big banks are significantly raising their dividends and buybacks. Banks like Bank of AmericaJPMorgan Chase, Citigroup, American Express, Capital One, all got approval for significant capital increases.

Jones: Yeah, absolutely! I'd have to agree, the positive surprise with Wells Fargo surprised and shocked many for a lot of different reasons. They can't really seem to stay out of the scandal news headlines. 

Deutsche Bank, not so much of a surprise. They've really been on the struggle bus for quite some time. I know they've also had a trickle of some top executive departures recently, as well. So, not too terribly surprising. I think if anything, with Deutsche Bank -- this is, again, the U.S. arm of Deutsche Bank -- the Fed actually said there were widespread and critical deficiencies with that particular bank's capital planning controls. There are also weaknesses in their data capabilities, controls supporting its capital process, and even concerns with how the bank forecasts revenues and losses under stress. So many red flags for Deutsche Bank there. Again, not too terribly surprising. 

I think for most investors that are listening or curious, in terms of, what are the takeaways? Should I be concerned with Goldman Sachs and Morgan Stanley not being able to do more with dividends and buybacks -- what do you say to that, Matt?

Frankel: In those two cases, not really. Like I mentioned, those were consequences of tax reform and not really anything having to do with the banks' businesses themselves. Both investment banks are doing well. This is a bad effect from tax reform that is ultimately going to have a very good effect on both banks. 

As far as the other banks, well, Deutsche Bank is considered a pretty troubled bank by just about anybody you ask. If you weren't worried about it, now, this really shouldn't add anything to the fire. This really wasn't a big surprise. 

For the other big banks, this is really just good news. Investors should be very happy. They're getting raises, the banks are buying back more stock, which will make their shares inherently more valuable, before the dividend increases. It's very good news all around.

The other one I forgot to mention was State Street Financial, which also got conditionally approved. Their capital plan was approved as is, they just have to go back and make a few tweaks to some of their processes. That stock, as well, investors shouldn't be terribly concerned. 

I would really say this was not a year of very big surprises when it comes to the stress tests. Everyone who we thought would get approved for a big dividend increase did. Some people thought Goldman especially would get approved for a little bit of a capital increase, and they didn't, but I wouldn't read too much into that. Like I said, that's tax reform. Goldman and Morgan Stanley both have a lot going for them. 

It's just all around, generally good news. You can tell by the banks' moves shortly after the announcement of the results how good news it was. Wells Fargo had a big pop, for example. But even Goldman Sachs and Morgan Stanley in the market didn't react negatively to it, and for good reason.

Jones: Absolutely. I think one of the bigger trends to watch moving forward will really be on buybacks. Tell us a little more about why buybacks will be a big trend to watch for investors.

Frankel: Since the financial crisis, buybacks have been the priority of banks. There's a couple of things worth noting here. One, buybacks generally convey to investors that management thinks that their stock is on sale. I mentioned this a little bit with Wells Fargo. They've been a massive underperformer in the financial sector since all of their issues started happening. This is management's way of saying, "Our stock is really cheap right now, we need to buy more of it." 

This made a whole lot more sense to most investors before, say, two years ago, when banks were still trading at fire sale valuations in the aftermath of the crisis. Now, banks have been the hottest-performing sector over the past few years. It's interesting that management's still emphasizing buybacks. It tells that they still think their shares are compelling value with all the positive catalysts -- tax reform, rising interest rates, a generally healthy economy. That's one thing to note. 

The other thing is -- Bank of America CEO, Brian Moynihan, pointed this out -- that a dividend is a much more flexible way to return capital, which is why they have chosen to prioritize them. I'd be pretty confident in saying that a lot of other banks are doing the same. In other words, if the bank runs into trouble, it's a lot easier, from a public perception point of view, to cut a buyback than it is to cut a dividend. A dividend cut makes headlines in the news the next day, it's a big sign of trouble. A lot of the stuff we write for The Fool is, "Oh, there's a dividend cut coming for X company."

A dividend is a very visible way of returning capital to shareholders. A lot of the banks are trying to be very conservative with their dividends -- in other words, keep them at a level that they can maintain even if things go poorly. Whereas, if Wells Fargo reduced its buyback from $26 billion to $25 billion, it really wouldn't be that much of a headline news as a dividend cut would be. 

In other words, it's easier to cut a buyback than it is to cut a dividend. That's one reason banks are putting as much money as they're allowed to in buybacks, knowing that if they have to step that back in coming years, then it's not as big of a deal as if they are required to reduce their dividend. 

Jones: Great points all around there, Matt. Really, in summary, with these stress tests, banks are much better off than they were previously, and most investors can expect to see capital returned to them. Good times all around.

That's it for this week's Financials show of Industry Focus. A few housekeeping notes for our loyal Industry Focus listeners. Due to the Independence Day holiday happening smack dab in the middle of this week, we'll not have the Tuesday Consumer Goods or Wednesday Healthcare Industry Focus podcasts airing. But, if you still need a Fool fix, be sure to check out Motley Fool Answers and Rule Breaker Investing. Those episodes will be airing this week. 

In addition, as many of you know, The Motley Fool is turning 25 -- that's right, it's The Fool's 25th anniversary. To celebrate, everything in the podcast swag store is 25% off. Just go to shop.fool.com and load up on all your podcast essentials between now and the end of July.

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Shannon Jones. Thanks for listening and Fool on!

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