The Federal Reserve administers the stress test every year to determine whether or not the nation's largest banks can survive an economic cataclysm akin to the financial crisis. It does so by presupposing two sets of adverse economic scenarios. The less stringent version is referred to simply as the "adverse" scenario; the more stringent one is the "severely adverse" scenario.
The central bank then models how banks will fare under each of these hypothetical fact sets based on their balance sheets and business models. For this year's test, for instance, the Fed made the following assumptions in the severely adverse version of the stress test:
- gross domestic product declines by 4.75% between the third quarter of 2013 and the end of 2014,
- the unemployment rate reaches 11.25% in the middle of 2015,
- equity prices fall nearly 50%, and
- housing prices drop by 25%.
Using these as a guide, the Fed then estimates how much capital -- specifically, Tier 1 common capital -- the banks are likely to lose and, as a corollary, have left when the proverbial dust settles. If a bank retains enough capital to meet the regulatory minimum, then it passes. If it doesn't, then it fails.
In Bank of America's case, as I've already noted, the good news is that it passed. It went into the stress test with a Tier 1 common capital ratio of 11.1%. During the test, it bottomed out at 6% before ultimately emerging with a ratio of 6.1%. Importantly, it at all times exceeded the 5% regulatory minimum.
Although this sounds great, it seems less so when you compare Bank of America to the other traditional banks on the list. As you can see in Figure 1, under the economic scenario, its Tier 1 common capital ratio declined by 46%. This was more than any other conventional lender with the exception of Zions Bancorporation, a much smaller Utah-based regional bank.
The source of Bank of America's decline was twofold. First, roughly 20% of the hypothetical capital losses derived from trading and counterparty issues. These are Wall Street-type activities generally associated with an investment bank -- think Merrill Lynch.
Second, albeit more significantly, 70% came from loan loss provisions -- these are what a bank sets aside to cover bad loans. Specifically, as you can see in Figure 2, Bank of America's hypothetical loan losses came principally from residential real estate, commercial loans, and credit cards.
What does all of this mean for Bank of America? On an absolute level, it means the bank is fine. It passed the stress test and has more than enough capital to increase its dividends or share buybacks -- that is, of course, assuming the Fed allows it to (which we should know on Wednesday).
On a relative basis, however, the results suggest that Bank of America still has one of the riskiest balance sheets in the industry; thus the reason its Tier 1 common capital ratio fell so much further than its competitors. With these two things in mind, in turn, the best that can be said is that this year's stress test was a mixed bag for Bank of America and its shareholders.
John Maxfield owns shares of Bank of America. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.