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Stress Test Distorts European Crisis: Analyst

NEW YORK ( TheStreet) -- The Federal Reserve's stress test models envision a much harsher downturn in the U.S. than Europe despite current reality , according to KBW analyst Frederick Cannon.

The Fed requires banks with large trading operations- Bank of America (BAC - Get Report), JPMorgan Chase (JPM - Get Report), Citigroup (C - Get Report), Goldman Sachs (GS - Get Report), Morgan Stanley (MS - Get Report) and Wells Fargo (WFC - Get Report) to conduct a stress on their trading book and private equity positions based on price and rate movements that occurred in the second half of 2008. The central bank focuses on that period because it was a time of severe market dislocations and the failure of a major globally active financial institution.

The banks will also have to consider additional stresses from the ongoing situation in Europe, although the scenarios envisioned in Europe aren't quite as harsh as one would expect.

"In trying to duplicate the financial crisis of 2008-09, in recreating that, the [test] assumes a downturn in Europe that is less severe than in the U.S. But the economic conditions are usually worse at the epicenter of the crisis," Cannon told TheStreet in an interview. "A more realistic scenario will be a deeper crisis in Europe and a lesser one in the U.S."

In its adverse stress scenario, for instance, the Fed assumes U.S. real GDP growth to drop by nearly 5% in the fourth quarter of 2011 and nearly 8% in the first quarter of 2012. In contrast, it assumes the real GDP growth in the Euro area- the 17 nations in the euro block- to decline by only 1% in the fourth quarter of 2011 and contract by about 4% in the first quarter of 2012.

Given that the stress test is modeling for a more severe downturn in the U.S. than in Europe, it is likely to be harsher on regional and domestically focused banks than it would be on the large global banks. In other words, the test applies more pressure on Wells Fargo than it would on JPMorgan, according to Cannon.

Still, the Fed's economic assumptions for Europe are much tougher than what the European bank stress tests have so far modeled. "The Fed is challenging European banking regulators to conduct tougher stress tests," said Cannon.
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