Bank Stress Tests And Black Swans

by: AAII

Most of the 19 banks examined by the Federal Reserve passed the new stress test. This examination was designed to see how United States' largest banks and financial institutions would hold up if another financial crisis were to occur.

The test looked at tier 1 capital. In simple terms, this test checked to see whether a bank's equity (equity capital plus retained earnings) was sufficient to cover a spike in bad loans. Put another way: Can each bank withstand a sharp rise in defaults among its outstanding loans? The idea is to prevent another situation where money needs to be infused into a bank to prevent it from failing. (Think of "It's A Wonderful Life," when Bailey Building and Loan needed a cash infusion from the townspeople because its tier 1 capital was too low.)

The news was viewed as a positive because most banks passed. JPMorgan Chase (NYSE:JPM) actually came out ahead of the Federal Reserve's press release with an announcement of both an increase in its dividend and a share buyback plan. BB&T (NYSE:BBT), State Street (NYSE:STT), U.S. Bancorp (NYSE:USB) and Wells Fargo (NYSE:WFC) also raised their dividends. (The Federal Reserve approved plans submitted by American Express (NYSE:AXP) to raise its dividend but the company has not yet announced an actual increase.) Four firms will have to submit plans to the Fed about how they will improve their capital structures, however. Those firms are Citigroup (NYSE:C), Ally Financial, MetLife (NYSE:MET) and SunTrust Banks (NYSE:STI).

The news led to a rally late on Tuesday, but there was little follow-through on Wednesday. Part of the reason is that the banks were already considered to be on more solid ground now than they were two years ago when the first stress test was completed. As a result, no one was expecting bad news from the Fed. Plus, banking stocks have performed well this year, so there was already good news priced in.

For the stress tests, the Fed assumed a scenario where the U.S. falls into a recession, stock prices drop by 50%, unemployment rises above 13% and both the European and Asian economies experience slowdowns. The scenario did not include explicit behavioral assumptions about what would happen between creditors and lenders. I point this out because such tests are typically based on what forecasters perceive could happen, not on what actually does happen. Panics are often caused by what are perceived as black swan events-low-probability scenarios with the potential to cause significant adverse events. Thus, the stress tests are not a guarantee that the banks can withstand another financial shock.

I'm not typing this to scare anyone, but rather to point out that all risk measures have their limitations. Just because a scenario can be modeled doesn't mean it will occur or that the outcome would be what forecasters expect. At the same time, investing based on the assumption of a severe macro-economic event occurring can cause you to miss out on market gains, resulting in the purchasing power of your savings being eroded by inflation.

Take confidence in the fact that the Federal Reserve is monitoring the major banks and asking the weaker ones to get stronger. The major U.S. financial institutions are getting stronger, and that's a good thing. At the same time, realize that all risk assessments have their flaws and that the latest exam provides no guarantee that another "too big to fail" situation won't occur.

Risks always exist, but understanding when the long-term opportunity for reward outweighs the potential for a loss has long been a successful recipe for building wealth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.