NEW YORK ( TheStreet) -- The results of the bank stress tests to be announced next week is expected to further ignite bank stocks, but given the sharp run-up in prices in the last two months and continuing overhang from Europe and regulatory issues, investors may have reason to be cautious.
The Federal Reserve's Comprehensive Capital Assessment and Review is an annual test conducted by the regulator to assess whether the country's largest banks can withstand a massive shock to the economy.
Banks will have to show that they can still maintain a Tier 1 Common Capital ratio of at least 5% even if they end up absorbing substantial losses in the event of a severe economic downturn. The harsh scenario includes a GDP contraction of 8%, a further decline in housing prices of 20% and an equity market crash of more than 50%.
Banks will also have to show that they are on track to meeting their capital requirements under new international rules or Basel 3.If the Fed is satisfied with the tests, it will go ahead and approve banks' requests to return capital to shareholders, either by way of dividend increases or buybacks or both. Analysts have largely been positive that banks will pass the stress tests and that most will win approval for their capital return plans. "The big message that will come out of the stress tests is that American banks are highly liquid, they have an excessive amount of capital and that they can withstand a fairly sizeable setback in the economy," Rochdale Securities analyst Dick Bove told Yahoo Finance's Breakout. "The second thing that will happen in week following the stress tests is that banks across country are going to be raising dividends and some will be announcing buybacks . I am assuming it is going to be a big buy signal for bank stocks and I will be shocked if it were not." Still, after a 35% rally in the KBW Bank Index, the stress test may not be such a positive catalyst. The expectations of who is poised to win from the stress tests vary widely as also estimates of how much banks will return to shareholders.