What Is the Bank Stress Test?

What is the bank stress test?

The country’s 19 largest banks have recently faced the toughest test they’ve seen to date. The Federal government, in anticipation of future financial troubles, has issued a “stress test” to these economic giants to determine what these banks need to do to prepare for the tough economic times ahead.

These banks were put through some paper simulations of potential future economic problems – to determine how they would respond and hold up under stress. Much like a patient with heart trouble will undergo “stress testing” to see how his or her heart responds, the nation’s big name banks were put to the test. Some of they key questions — What if unemployment rises to 10.3 percent? What if home prices plunge 22 percent? What if overall economic growth drops to negative 3.3 percent?

The most important consideration for banks to think about under such conditions is — what will happen to the banks’ balance sheets? Also trouble areas — what does the bank lose from increased defaults on mortgages, auto loans and credit cards? The results of these questions will reveal how much more money the banks really need to stock up on, probably as a handout from the government via taxpayers, to stay solvent and keep lending.

The idea behind the stress test was to show the stock market and other financial institutions that banks are stronger than people assume. In other words, the idea was to get positive results from banks to “prove” that the nation’s top 19 banks could stay solvent in even the most desperate of economic climates.

But there are two big roadblocks to this theory that treasury officials don’t know the answers to – at least not for certain. The government doesn’t know whether, instead of inspiring confidence, the stress test might actually undermine confidence in banks that fail or perform poorly on the test. Also, they don’t know if the remaining $350 billion in bailout funds available to banks will cover the complete need.

What were the bank stress test results?

We don’t know much about the results as of this writing – only a handful of banks have voluntarily released the results of their stress tests, although the treasury department expects to release the full results to the public “soon”.

Two of the nation’s largest institutions, JP Morgan and Goldman-Sachs, have already hinted to the public that they passed the test with flying colors. In fact, these two groups will probably be able to repay some of the money already given them, and avoid taking any of the money remaining from the government. This has inspired some good times on Wall Street, which anticipates similar results from the other 17 banking groups.

Unfortunately, early signs from other groups aren’t as optimistic. Even solid names like Wells Fargo, Citigroup, and Bank of America are showing up a bit in the red, and will likely need to bring in as much as $59 billion additional dollars just between the three of them. This far outweighs the government’s current financial commitment of just $35 billion.

There’s an even darker possibility for smaller banks like Regions Financial. These institutions have small market caps – in Region’s case, their cap amount is only $4 billion. If a bank this small needs to raise money and cannot find it in the traditional capital markets, a conversion of government shares could make taxpayers the largest shareholders, in effect nationalizing the banks. This would be of great concern to Wall Street.