Maybe it’s just us, but a stress test sounds… stressful.
It seems as though the country’s banks, which are currently undergoing their third round of stress tests, aren’t worried: The New York Times announced that 15 of the country’s 19 biggest banks have passed.
A stress test is an annual evaluation conducted by the Federal Reserve to determine whether banks have enough money that, in the case of economically stressful times, they would still be able to lend to households and businesses without serious issue.
But if we’re banking with an institution that doesn’t pass, should we be worried?
What Exactly Is a Stress Test?
Before we worry (or not), let’s review how a stress test works. The tests were developed after the recent recession, in order to temper another economic meltdown of such magnitude.
Essentially, the Fed takes stock of all of the bank’s assets, then applies them to a hypothetical situation with dramatically low employment, low equity prices and low housing prices. They take into account each bank’s emergency plans and determine whether the bank would still be operational were the economy to turn sour.
As with anything, the tests are subject to criticism. It has been said that the tests don’t evaluate the ability of banks to borrow during a recession, which was one of their key issues in the past few years. Passing stress tests also increases confidence in a bank, which—like J.P. Morgan did this year—might capitalise on that opportunity to buy back their stock and increase their dividend payments. Some people consider these moves irresponsible and premature, and think that the banks should continue focusing on gathering capital rather than spending it.
Winners and Losers
Some of the banks that came out with shining colours are J.P. Morgan, U.S. Bancorp, BB&D, Morgan Stanley, Wells Fargo and American Express. The only banks that didn’t pass the tests are Citigroup, SunTrust, MetLife and Ally Financial. (See the rest of the results here.) While having their emergency plans not pass is admittedly bad PR, it just means that they need to revise and resubmit their plans. In the meantime, the Fed can insist they delay their dividend payouts and raise more money.
So, should we panic and ditch a bank that didn’t pass its test? Probably not. The stress tests, aside from being a relatively new method of evaluation, are also measuring a bank’s solvency in a severe situation—not how they’re functioning today. Of course, we can’t predict which banks will and won’t hold out in the long run, but the stress tests are more of an informational tool than a proven predictor of how a bank will ultimately hold up.
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