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2014 Stress Tests Bring New Complications for Big Banks

NEW YORK ( TheStreet) -- The nation's largest banks will once again sail through the capital adequacy component of the Federal Reserve's 2014 stress tests, but the regulator is introducing plenty of additional complications for the next round of tests.

Over the past four years, the annual Federal Reserve stress tests and capital plan review for the nation's largest banks have been, for the most part, a time of celebration for investors. It's a two-part process. First, the Fed applies a "severely adverse" economic scenario to the banks' third-quarter financials, to gauge the banks' ability to withstand a two-year crisis while remaining well-capitalized with minimum Tier 1 common equity ratios of 5.0%.

The severely adverse scenario for the 2014 stress tests assumes an increase in the U.S. unemployment of four percentage points, with the unemployment rate peaking at 11.25% in mid-2015. The scenario also includes a decline in real U.S. GDP of nearly 4.75% through the end of 2014, a 50% decline in equity prices and a 25% decline in home prices.

The severely adverse scenario also has international components, including recessions Europe and Japan, and slowing growth in Asia.

The second part of the process is the Comprehensive Capital Analysis and Review (CCAR) which repeats the stress tests while incorporating the banks' plans to deploy capital through dividends, share buybacks or acquisitions.

There are two new twists this year. For starters, stress tests and CCAR for banks considered global systemically important financial institutions (G-SIFIs) will incorporate a counterparty default scenario that "involves the instantaneous and unexpected default of the bank holding company's counterparty with the largest net stressed losses." In other words, the stress tests will factor in the instant default of a bank's largest counterparty for trading of swaps and other derivatives.

U.S. G-SIFIs include JPMorgan Chase (JPM - Get Report), Bank of America (BAC), Citigroup (C - Get Report), Wells Fargo (WFC), Goldman Sachs (GS), Morgan Stanley (MS), Bank of New York Mellon (BK) and SunTrust (STI).

The second new twist is the "Global Market Shock" component of the severely adverse economic scenario, which the Federal Reserve describes as "one-time, hypothetical shocks to a large set of risk factors."

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