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Could Citigroup Have the Stress-Test Hiccups?

NEW YORK (TheStreet) -- The Federal Reserve will announce the results of its annual stress tests Thursday afternoon, and this year's results may be a whole lot more interesting than last year's, especially for Citigroup (C - Get Report).

The stress tests are a two-part process. The first -- the results of which will be announced Thursday afternoon -- measures large banks' ability to remain well capitalized through a "severely adverse" economic scenario, which 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. For the U.S.-owned holding companies being tested, this part of the scenario is most important for Citigroup, which derives the majority of its revenue and earnings from outside North America.

The second part of the stress tests is the Comprehensive Capital Analysis and Review (CCAR), which applies banks' plans to deploy excess capital through dividend increases, stock buybacks and/or acquisitions to the same "severely adverse" scenario. For bank-stock investors, CCAR is the more important part of the stress-test process. The Fed will announce those results on March 26, with most of the stress-tested banks expected to announce dividend increases and/or stock buyback plans the same day.

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The New Guys

The Fed this year has increased the number of banks going through the two-part process. The first part is known as the Dodd-Frank stress test, named after the massive Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law by President Obama in 2010.

The first major difference from last year is the addition of 12 more banks to this year's test group, bringing the total to 30. The new additions to the group include Discover Financial Services (DFS) and Northern Trust (NTRS) of Chicago, as well as four regional bank holding companies and six foreign-owned bank holding companies.

Here are the regional banks new to this year's Dodd-Frank stress tests:

  • Comerica (CMA) of Dallas.
  • Huntington Bancshares (HBAN) of Columbus, Ohio.
  • M&T Bank (MTB) of Buffalo, N.Y.
  • Zions Bancorporation (ZION) of Salt Lake City.

Here are the foreign-owned U.S. bank holding companies new to this year's stress tests:

  • BBVA Compass Bancshares, held by Banco Bilbao Vizcaya Argentaria, SA BBVA
  • BMO Financial, held by Bank of Montreal (BMO).
  • HSBC North America Holdings, a subsidiary of HSBC (HSBC).
  • RBS Citizens Financial Group, held by Royal Bank of Scotland (RBS).
  • Santander Holdings USA, a subsidiary of Banco Santander, SA (SAN).
  • UnionBanCal, which is held by Mitsubishi UFJ Financial Group.

New Stuff

There are two new elements in the tests this year that complicate things for the big banks. 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), Bank of America (BAC), Citigroup, Wells Fargo (WFC), Goldman Sachs (GS), Morgan Stanley (MS), Bank of New York Mellon (BK) and SunTrust (STI) of Atlanta.

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."

When announcing the stress test scenarios in November, the Federal Reserve said "Generally, these shocks involve large and sudden changes in asset prices, rates, and spreads, reflecting general market dislocation and heightened uncertainty." The Global Market Shock component of the stress tests will apply to the "big six" U.S. banks, including JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley.

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