Banking 101: Bank Stress Tests and You

There’s been a lot of talk about bank “stress” tests lately in Washington and on Wall Street.

But on Main Street, average Americans might be shrugging their shoulders and wondering what it all means.

So, just what are stress tests, anyway? The clinical definition from the Federal Reserve Board, which is administering the tests, says that they’re essentially financial fitness tests that evaluate the fiscal health of 19 key U.S. banks, including behemoths like Bank of America (Stock Quote: BOA); Wells Fargo (Stock Quote: WFC); and Citigroup (Stock Quote: C). The Treasury Department refers to stress tests as “forward-looking economic assessments”. Banks might differ on that -- some analysts imply that the stress tests are more akin to making banks dance on a hot griddle.

Griddle or not, the federal government says it wants rigorous financial check-ups of banks before Uncle Sam decides to provide any additional bailout money to banks; the overall goal of the stress tests.

The tests are broken down into two sections: a “baseline” test and an “adverse” test. Each projects likely, or at least potential, economic environments and then examines the balance sheets of participating banks to see how they’d cope with those specific economic situations.

The baseline criteria:

•    The U.S. economy falls 2%, as measured by Gross Domestic Product (GDP) in 2009, and increases by 2.1% in 2010.

•    Unemployment closes at 8.4% in 20099 and grows to 8.8% in 2010.

•    Housing prices fall 14% in 2009 and slide another 4% in 2010.

The adverse criteria:

•    The U.S. economy falls 3.3% in 2009 and grows by 0.5% in 2010.

•    Unemployment hits 8.9% in 2009 and rises to 10.3% in 2010.

•    Housing prices slide 22% in 2009 and fall another 7% in 2010.

If banks can’t handle the “stress” triggered by either economic situation, they’ll be asked to raise adequate capital within a six-month time frame. If that doesn’t work, the U.S. government could then step in and use taxpayer money for yet another bank bailout. Or, it could simply allow a bank to fail.

For the U.S. government, the tests provide political cover if the Treasury Department has to go back to Congress asking for more bailout money. For banks, the test provides a dose of confidence those that pass, and another dose of protection for banks that don’t.

For bank customers, it’s also a confidence issue. Presumably, if a bank issues a weak response to its respective stress test, customers will be made aware. If the government decides to go public with the actual results, a lot more about that bank’s financial health will be revealed and customers can then choose to take their assets to a stronger bank.

For investors, any news of a bank that fared poorly on the stress test might lead to a run away from weaker banks and toward stronger ones.

In other words, the bank stress tests are the Washington/Wall Street version of survival of the fittest. Stronger banks may devour more incoming assets and weaker ones will lie in the tall grass and possibly bleed to a financial death.

In the end, no matter the results, bank customers should rest assured that assets in all 19 banks currently under examination are insured up to $250,000 per depositor by the Federal Deposit Insurance Corporation (FDIC).

Hopefully that’s something that will help reduce some stress for bank customers, if not for the financial institutions that do in fact fail.

Related Stories:

•    The Strongest Banks Out There
•    Banking 101: How Banks Make Their Money
•    Who's to Blame? Banks

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