) -- 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



(C) - Get Report


Goldman Sachs

(GS) - Get Report


Morgan Stanley

(MS) - Get Report


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


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.

In fact, a tougher European stress tests rather than U.S. bank stress tests might actually be the real catalyst for the large U.S. bank stocks. The large banks have remained highly correlated to Europe, notes Cannon.

He says European regulators need to apply the same rigor in their stress tests and get European banks to raise a ton of capital, which will be bad for European bank shareholders but will lend more credibility to the regulators. That would in turn benefit U.S. banks.

For now, investors should avoid large U.S. banks, the analyst says. The measures are robust enough that if U.S. banks do pass the stress test, investors should feel comfortable about their health. But KBW expects the stress test to lead to a delay in capital deployment.

"The Fed appears very much to be trying to get banks to keep capital and increase it," said Cannon. "If you got capital tied up in large-cap banks do not expect returns for a while," he said.

In the near term, KBW recommends investors stick to smaller regional banks that are not exposed to Europe and would also not be restricted in their capital deployment plans.

New York Community Bancorp


is one such bank, the analyst says.

For those who don't want to avoid stocks that are relatively illiquid, he recommends exposure to an ETF -

PowerShares KBW Regional Banking

(KBWR) - Get Report

, which has a basket of regional banks which should fare well on a relative basis.

--Written by Shanthi Bharatwaj in New York

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Shanthi Bharatwaj


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