On Friday, the Federal Reserve released the Dodd-Frank Act supervisory stress test 2019 (DFAST 2019) results, which, to a great extent, reflect the stability of the banking system. In fact, this reaffirms that U.S. banking giants are adequately capitalized to survive under a tremendously difficult economic scenario.
Due to some regulatory changes last year, 18 of the 35 banks were part of DFAST 2019. All 18 banks, which submitted their capital plans to the Fed, have passed the first round of test. Notably, smaller banks, including BB&T Corporation (BBT - Free Report) , SunTrust Banks (STI - Free Report) , and Citizens Financial Group (CFG - Free Report) , were exempted from the stress test this time.
“The results confirm that our financial system remains resilient,” Fed vice chairman Randal Quarles said in a statement. “The nation’s largest banks are significantly stronger than before the crisis and would be well-positioned to support the economy even after a severe shock,” noted Quarles.
Nevertheless, the clearance of the stress test does not automatically lead to the conclusion that the banks qualify for additional capital deployment. The banks will have to wait till Jun 27 for approval of their capital plans.
This year’s stress test as compared with the last year reflected “severely adverse” scenario featuring a steeper downturn in the U.S. economy, with real GDP shrinking around 8% as compared to the pre-recession peak. Moreover, the 10-year Treasury declined to a trough of around 0.75%. Furthermore, in equities, the banks were required by the Fed to factor in substantially more volatility, with the U.S. Market Volatility Index (VIX) reaching 70%.
Under this hypothetical scenario, these banks will incur a loss of $410 million, which improved from total losses of $464 billion projected in the worst-case hypothetical scenario for the 18 firms in 2018. Also, the Common Equity Tier 1 (CET1) capital ratio (in aggregate) would fall to a low of 9.2% from an actual 12.3% in fourth-quarter 2018. Notably, the figure is well above the 4.5% minimum mark set by regulators.
This scenario also included a global recession with the U.S. unemployment rate increasing 6-10%, along with slump in real estate prices and heightened stress in corporate loan markets.
Notably, banks continuing with the annual stress test for nine years, included JPMorgan Chase & Company (JPM - Free Report) , Bank of America Corporation (BAC - Free Report) , Citigroup Inc. (C - Free Report) and Wells Fargo and Company (WFC - Free Report) . These four banks are the largest U.S. banks by assets. Among these, Citigroup and JPMorgan currently carry a Zacks Rank #2 (Buy) and Zacks Rank #3 (Hold), respectively. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Further, as announced earlier, smaller and less complex banks exempted from this year’s test are currently on a two-year cycle as required by the Economic Growth, Regulatory Relief, and Consumer Protection Act. Notably, the participating 18 banks hold around 70% of all U.S. bank assets.
Root of the Stress Test
Currently authorized under the Dodd-Frank financial-services law, the stress tests were introduced after the 2008 financial crisis. During this economic downturn, big financial institutions like Lehman Brothers collapsed and several other big banks were also on the verge of a collapse. The situation compelled the U.S. government to infuse billions of dollars into credit markets and save the entire financial system from crashing. Stress tests have been annually conducted since 2009.
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. This will 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.
Nevertheless, the central bank’s approval to increase dividend payment and accelerate the share-buyback program will definitely help banks attract more investments, in the days ahead. Thus, it can be said that the economy is on the right track to sustained recovery.
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