Before the financial crisis of 2008 was over, both the U.S. government and the financial services industry had leapt into action to create both immediate and long-term strategies for strengthening both industry participants and the regulatory framework. These took the form of TARP, BASEL’s new capital requirements, the Dodd-Frank Act, and the stress tests of 2009.
In November of 2011, the federal banking regulators asked 31 large U.S. banks to conduct a new stress test. Soon the regulators will announce the results of those tests. The purpose of the stress tests has been viewed in many conflicting ways, so let’s talk about what the stress test is all about.
The stress test is designed to study the impact of an extreme economic downturn on the capital levels the largest banks. In other words, if a doomsday economic scenario ever occured, would banks still have sufficient capital to meet supervisory standards? It is the most aggressive stress test ever issued by the Fed, (much more severe than the 2009 stress test scenario). The Federal Reserve has stated that the stress tests are neither a forecast nor a projection for the U.S. economy, nor do they take into account any actions a bank could take to mitigate the impact of a real crisis.
The stress tests are not a reflection of the current solvency of any particular bank. The Fed’s hypothetical economic scenario itself is highly, highly unlikely. You can read more about the severity of “adverse scenario” here. The stress tests ask banks to assume unemployment of 13%. In fact, the unemployment rate has never gone over 11% (let alone reach 13%) since the Great Depression. The stress test assumes the Dow drops to 5,700. In fact, the lowest quarterly Dow close during the most recent recession was 8, 113.14 (during the first quarter of 2009). The stress tests also ask banks to assume the GDP growth drops to negative 8%. In fact, GDP has dropped by 8% or more only two times since 1947: Q4 2008 (-8.9%) and Q1 1958 (-10.4%).
The reality is that if the Fed’s hypothetical “adverse scenario” ever occurred, it would be catastrophic across the majority of all industries. According to Moody’s Analytics, if the scenario were to come true; 4.5 million additional jobs would be lost by the end of 2012; national debt will increase by an additional $1 trillion by mid-2013; and retail sales would be down 10% by the end of 2012. In particular car sales would drop off by 5 million (33% lower than projected sales) – creating serious trouble for GM & Ford.
The good news it that U.S. banks currently have $1.5 trillion in capital, the highest capital-ratio levels in history, according to FDIC data. Capital ratios of large U.S. banking organizations have risen well about supervisory benchmarks. So while banks might not make it through a doomsday without a capital hit, they are expected to perform well given the scenario.
Moreover, banks are stronger than even pre-crisis. The risky lending practices have ended, compensation incentives have been overhauled, and the concept of too big to fail is gone. Insurers have remained solvent throughout a decade that saw a record number of natural catastrophes. Banks have stronger balance sheets, and bank repayment of the TARP investments is on course to deliver over $21 billion in profit to taxpayers.
You can read more about the current health of the financial system in the recently released Hamilton Financial Index.