A drop of 8% in GDP, 13% unemployment, and another period of interrupted access to the capital markets… Those are just some of the new Federal Reserve stress test scenarios which banks will have to be able to withstand once a new stress test is administered in 2012 for the US-based bank holding companies with total consolidated assets of $50 billion or more.

The goal is to “ensure that institutions have robust, forward-looking capital planning processes that account for their unique risks, and to help ensure that institutions have sufficient capital to continue operations throughout times of economic and financial stress.”  The Fed noted that these banks will be expected to have credible plans proving sufficient capital so that they can continue to lend to households and businesses under highly adverse conditions.

The Federal Reserve will evaluate the institutions’ capital adequacy annually, will assess internal capital adequacy, and will review these banks’ plans to make capital distributions via dividend payments or stock buybacks.  If you are looking for a huge dividend returning immediately from Bank of America Corporation (NYSE: BAC), Citigroup Inc. (NYSE: C), or other “stressed banks,” be advised that the Federal Reserve will approve dividend increases or other capital distributions “only for companies whose capital plans are approved by supervisors and are able to demonstrate sufficient financial strength to operate as successful financial intermediaries under stressed macroeconomic and financial market scenarios, even after making the desired capital distributions.”  In short, passing a stress test doesn’t matter.  A bank will have to prove that it can pass the stress test even after it pays out a dividend or uses capital to repurchase shares.

Another aim is to see which banks will survive even in an unlikely deep recession.  The six largest firms will be required to estimate potential losses stemming from a hypothetical global market shock, based on market price movements seen during the second half of 2008 and with adjustments made to incorporate potential sharp market price movements in European sovereign and financial sectors.

Any capital distribution plans will be based upon projected performance under the stress scenarios and these institutions will be required to submit their capital plans by January 9, 2012.

More details are here.  To all of the banks: “Good luck!”  They will need it.

JON C. OGG

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