Going into this year's stress tests, there was little reason for investors to worry about whether JPMorgan Chase (NYSE: JPM) would pass the annual exam. Now that the results are in, for the first round of the stress tests anyway, it's clear that there was no reason for concern.
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The purpose of the stress tests is to see whether the nation's biggest banks, those with more than $50 billion in assets on their balance sheets, have enough capital to survive an economic downturn akin to the financial crisis. The Federal Reserve does this by assuming that the economy dives into a deep recession, the unemployment rate soars to 10%, and that asset values and interest rates plummet, among other things.
After taking assumptions like this into consideration, the Fed then projects what would happen to bank balance sheets if the projections were to come to fruition. So long as a bank retains enough high-quality, highly liquid capital to survive the hypothetical economic downturn and continue lending through it, then the bank will pass. Otherwise, it will fail.
The controlling threshold in the analysis is the common equity tier 1 capital ratio, or CET1 ratio. A bank will pass so long as it maintains a CET1 ratio of at least 4.5%.
Going into this year's test, JPMorgan Chase had a CET1 ratio of 12.5%. There's no reason to get bogged down in the details of how this is calculated, but this means that the nation's biggest bank by assets had $117 billion in high-quality capital in excess of the 4.5% minimum.
This was far more than enough to absorb the $18.3 billion in net losses that JPMorgan Chase was projected by the Fed to lose over the nine-quarter horizon of this year's stress test. According to the Fed's estimates, even in an acute downturn along the lines of the 2008 crisis, JPMorgan Chase would see its CET1 ratio fall to a minimum of 9.1%, which is more than twice the regulatory minimum.
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This goes a long way toward explaining why the stress tests are no longer as stressful of an exercise for banks like JPMorgan Chase as they once were. These results should also put shareholders of the New York-based bank at ease over its likely performance on the second round of the stress tests, the results of which are set to be published next week.
The second round, known as the Comprehensive Capital Analysis and Review, or CCAR, is especially important because it dictates whether a bank can increase the amount of capital it returns to shareholders by way of dividends and share buybacks.
In JPMorgan Chase's case, the bank is expected to get approval to raise its quarterly dividend by $0.04 per share and its annual share buybacks by over $6 billion. These projections were made before the results from the first round of the stress tests were released last week, but given its performance, there's no reason to think that they should change.
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