The Federal Reserve yesterday announced the results of the stress tests and 29 out of 30 participants passed the test. Bank of America (NYSE:BAC) was also one of the participants and the bank's capital ratio was enough to satisfy the demands of the test. The stress test is a tool to gauge the bank's ability to meet its obligations and run its operations under different scenarios. The test uses three scenarios: Baseline, Adverse and Severely Adverse - the focus is mainly on the adverse and severely adverse scenarios as these scenarios show a financial institution's ability to perform under poor economic conditions.
The severely adverse scenario assumes recession in the developed economies such as the United States, Europe and Japan, considerable economic slowdown in the developing economies, increase in the risk premiums and significant decrease in the asset prices. The economic growth rates and unemployment rates are adjusted for the scenario in order to create a hypothetical global recession. On the other hand, the adverse scenario assumed weakened economic activity across all economies, rapid rises in long-term interest rates and steepening yield curves due to the aversion to long-term fixed assets. The balance sheets and the income statements of the banks are projected under these scenarios and the capital ratios are calculated in order to test the financial strength of these banks and their ability to operate under tough conditions. The Federal Reserve views 5% as the lowest limit for the Tier-1 common ratio and for a bank to pass the test - it should have common ratio of at least 5%.
I touched on the topic in my previous article to give readers an idea where Bank of America stood in terms of the stress test. In the 10-K filing the bank gave the following table, which clearly shows that Bank of America was well set for the test.
Although the ratio slightly declined for the bank, it was enough for the stress test. Bank of America's common ratio in the severely adverse scenario was 6%. Other major banks such as Goldman Sachs (NYSE:GS), Citigroup (NYSE:C), JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) were able to demonstrate better capital ratios under the scenario. The ratios for JPM, GS and C were 6.3%, 6.8% and 7.0%, respectively. However, Wells Fargo was able to beat all these banks with a far stronger capital ratio of 8.2. Nonetheless, the result for all these banks is the same and only one participant was not able to cross the threshold of 5%.
An important part of this stress test is to evaluate a bank's ability to distribute its capital - dividends and stock buybacks. The Federal Reserve will announce further results on March 26, which will include the decision about capital distributions by the banks. In this phase, the Federal Reserve will look at the qualitative findings in order to make a decision about allowing the banks to return capital to investors - passing the quantitative test does not ensure the permission to start or increase dividends, or start share buyback plans. Bank of America was given the permission to buy back shares last year. It is certainly good news for the company to pass the stress test and it will further increase confidence in the bank.
If the Federal Reserve allows banks to further enhance the dividends and share buybacks, then we will see the banking sector perform even better. Overall, the banking sector has been performing well since the start of the year, and the positive news about the stress test as well as the decision to increase dividends or share buybacks will further enhance the investor confidence in the sector. Bank of America surely has some litigation issues. However, as I have mentioned in my previous articles, the fundamentals of the bank and the sector are improving which should result in a higher valuation over the next few months.