Flying colors or 'must do better'?

The Federal Reserve is set to publish the second stage of its bank stress tests results Thursday in a report that will signal whether the country's biggest lenders will be able to boost dividends, increase share buybacks or accelerate business investment.

The tests, devised by the Fed in the wake of the global financial crisis, are designed to both asses the ability of the country's 35 biggest banks to withstand a sharp economic slowdown and to gauge their broader earnings potential by approving or deny capital deployment and business plans submitted by management. 

"Can large U.S. banks hand $170 billion to their shareholders in the next 12 months? Will a top European investment bank botch the first public stress test of its entire U.S. business?," wrote Hong Kong-based Hongta Securities. "While investors got hints during the first stage last week, the central bank has repeatedly found ways to surprise in past reviews of banks' risk management and proposed cash payouts."

However, despite clearing the first hurdle of the Fed's two-part tests last week, U.S. banking stocks have notably under-performed the broader market of late, with the S&P 500 Financials index falling for the past 13 sessions and giving back 3.4% over the past week alone. 

Citigroup (C) - Get Report , one of the banks expected to win approval for increased payouts, was marked 1.65% higher and changing hands at $66.44 each by mid-day in New York Thursday while rival Bank of America Corp. (BAC) - Get Report was seen 1.49% to the upside at $28.66. Warren Buffett-backed Wells Fargo & Co (WFC) - Get Report edged 0.3% while Goldman Sachs (GS) - Get Report was seen 1.31% to the good at $223.09. JPMorgan Chase & Co. (JPM) - Get Report shares were seen 1.33% higher at $104.61.

Bank stocks could be caught in the broader global equity market concern of slowing economic growth and, by extension, a looser approach to monetary policy from the world's major central banks, both of which would blunt the ability for banks to improve lending margins and increase profitability.

U.S. Treasury bond markets have reflected a portion of that concern as the so-called yield curve 'flattens' in the face of weaker economic growth prospects. That flattening, which describes the difference between short and longer-term government borrowing costs, has narrowed the gap between 2-year and 10-year note yields to just 32 basis points, the smallest since 2007.

Last week the Fed said that all 35 of the banks it monitors passed the first phase of the test, which showed that the $800 billion in capital they've collectively added to their balance sheets would be more than enough to absorb the estimated $578 billion in losses that would stem from a global recession and a spike in unemployment that would take the U.S. jobless rate to 10%.

"Despite a tough scenario and other factors that affected this year's test, the capital levels of the firms after the hypothetical severe global recession are higher than the actual capital levels of large banks in the years leading up to the most recent recession," said Fed vice chairman Randal Quarles.

One bank that may not emerge victorious from the Fed's second assessment, however, is Deutsche Bank AG (DB) - Get Report , whose shares remain within touching distance of yesterday's all-time low amid concerns for both its financial health and the broader turnaround plans of new CEO Christian Sewing.

Deutsche Bank shares were marked 0.4% lower at €9.01 each by mid-day in Frankfurt, taking their year-to-date decline past 43%. 

"Deutsche Bank may have difficulties with the second part of the stress test as the bank has failed the test in the past," ING analysts wrote Thursday. "In addition, in June the Fed added it to a list of "troubled lenders" warranting special monitoring according to press, a hint that the problems have not yet been fixed. A failure in the test would be a credit negative but it has been to a large extent already priced in in the form of wider spreads in our view."