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TheStreet Open House

Why You Should Celebrate Bank Stress Tests

Stocks in this article: CJPMGSMSSTTBK

NEW YORK (TheStreet) -- The Federal Reserve will announce the results of its annual stress tests for major U.S. bank holding companies on March 20, but bank stock investors are looking ahead to March 26, when the regulator releases results of its annual reviews of the banks' plans to return capital to investors.

While "stress tests" is the term that dominates the headlines, the Comprehensive Capital Analysis and Review (CCAR) is the more important event, because most of the nation's largest banks will follow up that announcement with their own announcements of plans to deploy excess capital through the first quarter of 2015. Most of the capital deployment will come in the form of dividend increases and share buybacks. Most of the big banks have been reducing their count of outstanding shares through buybacks over the past few years, which boosts earnings-per-share, supporting higher stock prices.

The stress tests are based on Sept. 30 financial reports and gauge the banks' ability to remain well-capitalized, with minimum Tier 1 common equity ratios of 5%, through a "severely adverse" economic scenario. This year's scenario 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.

So investors and taxpayers can take some comfort that the Federal Reserve, at least, believes banks passing the tests won't need to be bailed out if quickly we enter another financial crisis.

One major addition to this year's stress tests is that 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 swaps and other derivatives.

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

Also new to the 2014 stress tests is a "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."

Analysts expect most of the banks subject to the stress tests to "pass," the stress tests. When the results of the 2013 stress tests were announced in March of last year, the only bank holding company not making the grade by showing the ability to maintain a 5.0% Tier 1 common ratio through that test's adverse scenario was Ally Financial, the former GMAC, which is majority-held by the U.S. government, which has received $12 billion in federal bailout funds through the Troubled Assets Relief Program, or TARP.

And Now, the Goodies

The Fed will announce the CCAR results at 4 p.m. ET on March 26. Most of the banks subjected to the capital plan reviews are expected to announce their own capital deployment plans right after the regulator's announcement. The capital plans run from the second quarter of 2014 through the first quarter of 2015. Last year's CCAR included the 18 banks subject to the Fed's stress tests. This year's CCAR will be expanded, to include regional banks with total assets of more than $50 billion, which were previously included in a different program called the Capital Plan Review, or CapPR.

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