(BAC) Federal Reserve Requires More Stress Tests

The Federal Reserve requires more banks to submit their capital plans annually to prove their financial ability to confront another recession. The Federal Reserve will also hold the right to ban capital deployment activities of unsuccessful banks.

This is part of Federal Reserve’s effort to closely monitor capital ratios of banks and identify systematic risk in advance in order to avoid recurrence of the latest federal bailout program.

According to a proposal on Friday, the Federal Reserve said that it will extend its existing list of 19 big banks that are subject to the capital assessment scheme to 35. The Fed expects the proposal to be finalized later this year and the capital review for these banks will be compulsory by 2012.

According to the ruling by the Federal Reserve, if these banks want to increase their shareholder returns through dividend hikes, they can resubmit their capital plans in between their annual capital assessments.

The Federal Reserve perhaps wants to ensure that banks are more cautious about dividend payments and share buybacks, particularly after they had to shell out billions of dollars as government reimbursement by tapping the capital market.

The Story Behind

In January, all 19 banks regulated by the Federal Reserve including Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM), Wells Fargo & Company (WFC), The Goldman Sachs Group Inc. (GS) and U.S. Bancorp (USB) faced a rerun of the stress test. In the latest round, these banks were required to demonstrate that they have adequate capital to address losses over the next two years under any untoward situation.

The latest round of stress test was dissimilar in character to the first round conducted during the middle of the recession in 2009, which had estimate how much banks would lose if the economic downturn proved even deeper than feared. The rerun was, on the other hand, was basically a precautionary exercise amid economic recovery.

Also, as the banking industry swung back to profitability in 2010, big banks began pressing regulators to allow them to enhance shareholder value through dividends and buybacks.

Following the release of the second round of stress test results in March, many big banks that were granted the green signal took immediate action to raise their dividends.

New Banks Under Review

Banks with assets of $50 billion or more would be required to submit capital plans. These banks, including M&T Bank Corp. (MTB), Comerica Inc. (CMA) and Northern Trust Corporation (NTRS), will be subject to a capital surcharge in addition to meeting international capital standards (such as Basel III).

A Cautionary Tale

Though one may think that restrictions on capital distribution will make the shares of these banks unattractive for investors, the decision to make them undergo stress tests once every year is actually a good way keep another financial catastrophe away.

Surely, after learning a lesson from the latest recession, Americans will never wish to go back to those dreadful days only to earn higher capital rewards from their banks.

Hopefully, disciplined reruns of stress tests will also prevent the big banks from flirting with risky activities that jeopardize economic health. The annual stress tests would also play a major role in abating threats to the economy by forcing banks strengthen their capital levels.

Most importantly, the stress tests could ultimately translate to less involvement of taxpayers’ money for bailing out troubled financial institutions.

BANK OF AMER CP (BAC): Free Stock Analysis Report

COMERICA INC (CMA): Free Stock Analysis Report

GOLDMAN SACHS (GS): Free Stock Analysis Report

JPMORGAN CHASE (JPM): Free Stock Analysis Report

M&T BANK CORP (MTB): Free Stock Analysis Report

NORTHERN TRUST (NTRS): Free Stock Analysis Report

US BANCORP (USB): Free Stock Analysis Report

WELLS FARGO-NEW (WFC): Free Stock Analysis Report

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