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American banking giants, along with subsidiaries of certain foreign banks will have to undergo another round of stress tests early next year. Last week, the Federal Reserve revealed the three stress test scenarios – baseline (based on expectations of private economists), adverse and severely adverse. This will mark the sixth round of bank stress tests since 2009.

The Fed has added 12 more financial institutions this time to its previous list of 18. These banks will have to prove their financial capability of withstanding another recession and enhance or maintain their capital plans.

The periodic tests evaluate the financial stability of the banks under hypothetical stressful situations. These banks come under the Fed’s Comprehensive Capital Analysis and Review (CCAR), which is conducted in compliance with the stress test rules of the Dodd-Frank Act. Some of the newly added financial institutions were previously part of the Capital Plan Review (CapPR).

Similar to prior tests, the six major banks, namely Citigroup Inc. (C - Analyst Report), Bank of America Corp. (BAC - Analyst Report), JPMorgan Chase & Co. (JPM - Analyst Report), The Goldman Sachs Group, Inc. (GS - Analyst Report), Morgan Stanley (MS - Analyst Report) and Wells Fargo & Company (WFC - Analyst Report), will have to demonstrate their capability to endure significant global capital market shocks. The Fed will soon reveal the scenarios related to this.

Alongside, The Bank of New York Mellon Corporation (BK - Analyst Report) and State Street Corporation (STT - Analyst Report) will incorporate a counterparty default scenario. This will replace the counterparty incremental default risk calculation of the prior year’s stress test.

The newly added banks include Comerica Inc. (CMA - Analyst Report), Discover Financial Services (DFS - Analyst Report), KeyCorp (KEY - Analyst Report), Zions Bancorp. (ZION - Analyst Report) and the subsidiaries of foreign banks such as BMO Financial, a unit of Bank of Montreal (BMO) of Canada; BBVA Compass Bancshares, held by Spain’s Banco Bilbao Vizcaya Argentaria SA (BBVA) and Santander Holdings USA, which is held by Spain’s Banco Santander SA (SAN).

The environment at the time of the last four rounds of stress tests was quite different from that of the first round of tests conducted by the Fed. The first round, conducted when the country was under considerable recessionary pressure, was meant to draw an estimate of how badly the banks would fare if the economic downturn proved more devastating than expectations. Since then, the test rounds are more like precautionary measures amid the economic recovery.

Test Scenarios

Each of the three scenarios include 26 different variables (similar to the earlier stress test) such as employment and exchange rates, the anticipated changes in GDP, economic activity, prices, interest rates and a substantial weakness in emerging economies.

Further, the Fed will test the banks’ balance sheet under the impact of slowdown across economies and severe recession in the U.S., Europe and Japan, leading to about 50% fall in equity prices. Other stressful circumstances include unemployment rate reaching 11.25%, home prices declining nearly 25% and the U.S. GDP falling 4.75%.

The Requirements

The banks are required to file their capital plans by Jan 6, 2014 to undergo the new tests. They will have to adhere to this requirement even without any plan of enhancing shareholder value. The banks intending to boost shareholder value (through dividend hikes and share repurchases) will have to prove their capability to reach minimum Tier 1 common equity ratio of 5% through 2015.

Moreover, banks are getting an opportunity to revise their capital plans, in order to prevent a failure to clear the stress test in the initial assessment. This will furnish the banks with an opportunity to amend their capital plans, thereby lowering the probability of a bank failing the stress test.

A Road to Recovery

Conducting the stress test is a prudent step by the Fed to evaluate the overall performance of the banking sector. These tests help banks to gear up and improve their weak capital levels, which always threaten the economy. In the second quarter of 2013, the 18 banks increased their Tier 1 common capital to $836 billion from $392 billion at the end of second quarter 2009.

In addition, stress tests will likely translate into less involvement of taxpayers’ money for the bailout of troubled financial institutions.

While the government has been closely monitoring major banks and extended aid through various programs, many smaller banks are still struggling to stay afloat. Though there has been a rebound in home prices, rising loan defaults and the high unemployment rate continue to weigh on small institutions. However, if most of the major banks pass the stress tests, it would be a much-needed boost in the economic recovery.

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