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On Thursday, the Federal Reserve released the Dodd-Frank Act supervisory stress test 2013 (DFAST 2013) results, which reflects stability in the banking system to a great extent. Actually, this confirms the ability of U.S. banking giants to survive under a tremendously difficult economic scenario.

Among 18 bank holding companies which submitted their capital plan to the Fed in Jan 2013, the auto lender, Ally Financial, majority-owned by U.S. taxpayers, failed to meet the minimum requirement of 5% Tier 1 common capital ratio. With 1.5% capital ratio, Ally remains unstable, struggling with troubled mortgages and other distressed businesses.

However, the remaining 17 banks that have capital ratio above 5% now have the privilege to alter their capital plans within 48 hours from the time of this result release. The Fed’s approval on these banks’ capital plans is expected on Mar 14.

Root of the Stress Test

Currently authorized under the Dodd-Frank financial-services law, the stress tests were first introduced after the 2008 financial crisis. During this economic downturn, big financial institutions like Lehman Brothers and AIG collapsed and several other big banks were at the verge of a collapse. Such a situation compelled the U.S. government to infuse billions of dollars into credit markets and save the entire financial system from failing.

The prior tests were conducted during early 2012, 2011, late 2010 and 2009. The periodic stress tests monitor the 19 banks that are regulated by the Fed, but MetLife Inc. did not participated in DFAST 2013 due to its ongoing process of deregistering as a bank holding company.

The environment of the last 3 rounds of stress tests along with the latest one is quite dissimilar to the Fed's first round. The first round, conducted when the country was teetering under tremendous recessionary pressure, was aimed at estimating how much the banks would lose if the economic downturn proved deeper than expected. Since then, the stress test rounds are precautionary measures amid an economic recovery.

The Federal Reserve’s latest stress test scenario projections include input data supplied by the 18 banks participating in DFAST 2013 and models created by the regulatory staff and evaluated by a group of Fed economists and analysts. These models were developed with the intention to inculcate the impact of the macroeconomic and financial market factors that are included in the Supervisory Stress Scenario and distinctive factors of the banks’ loans and securities portfolios, trading as well as other factors affecting losses, revenue and expenses.

Moreover, the Fed's stress test was conducted to find out whether the banks have enough capital to survive another financial crisis, including a hypothetically 12.1% unemployment rate, more than 50% fall in stock prices, more than 20% drop in housing prices along with an economic downturn in developing Asia.

Moreover, profound recession in the U.S., Europe and Japan was featured along with expected trading losses of $462 billion at the 18 bank holding companies during the 9 quarters of the theoretical stress scenario. Further, tier 1 common capital ratio was anticipated to fall from an actual 11.1% in the third quarter of 2012 to 7.7% in the fourth quarter of 2014 in the hypothetical stress scenario. The requirements in the fifth round of stress test was tougher compared with the prior ones.

Further, as per the Dodd-Frank Act, bank holding companies participating in the Fed’s stress test rules have to conduct two company-run stress tests each year. Moreover, they have to publicly unveil a summary of the results of the company-run stress tests conducted under the strictly adverse scenario given by the Fed.

Successful Banks

Among 18 participating banks in the stress test, smaller banks compared to Wall Street biggies like Morgan Stanley (MS - Analyst Report), JPMorgan Chase & Co. (JPM - Analyst Report) and The Goldman Sachs Group, Inc. (GS - Analyst Report) performed well. With 13.2% capital ratio, The Bank of New York Mellon Corporation (BK - Analyst Report) was the best performing bank.

Notably, Citigroup Inc. (C - Analyst Report) which failed the test last year, recorded tier 1 common capital ratio 8.3%. Moreover, in its latest capital plan, Citi has asked for $1.2 billion worth of share repurchases through the first quarter of 2014 and no change in its dividend levels. The company had no share buyback plan before and currently pays quarterly common stock dividend of 1 cent per share.

Among other major banks, Bank of America Corporation (BAC - Analyst Report) and Wells Fargo & Company (WFC - Analyst Report) with 6.8% and 7% capital ratios, respectively, fared well compared with the prior-year test.

Further, JPMorgan held a steady capital ratio of 6.3%. However, two major Wall Street big shots - Morgan Stanley and Goldman recorded 5.7% and 5.8%, the lowest results above the minimum requirement of 5%.

Recovery on the Way

This is not the final round. The big banks will have to undergo the Fed’s stress test once every year. These would help build up the weak capital levels of banks, which are always a threat to the economy. Also, this could ultimately translate to less involvement of the taxpayers’ money for bailing out troubled financial institutions.

However, the government must necessarily set some policies so that every industry participant contributes to the overall profitability. While the bigger banks benefited greatly from the various programs launched by the government, many smaller banks are trying hard to catch up.

Yet, the banking sector presented a slightly improved picture in 2012 compared to 2011. Nagging issues like depressed home prices, loan defaults and unemployment levels are not so prominent compared to the last few years.

Though economic uncertainty still lingers, banks are actively responding to every legal and regulatory pressure. In fact, this has positioned the banks well to encounter impending challenges. As the sector is undergoing a radical structural change, it is expected to witness headwinds in the near to mid term. But entering the new capital regime will significantly improve the industry’s long-term stability and security.

Nevertheless, the approval from the Federal Reserve to increase dividend payment and accelerate share buyback program will definitely help banks attract more investments going forward. So it can be said the economy is on the right track to recovery.

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