At the end of June, the Federal Reserve released the results of this year's stress tests, the purpose of which are to make sure that large banks have enough capital on their balance sheets to survive a severe economic downturn akin to the financial crisis.
The most important metric that the Fed uses to determine this is the common equity tier 1 capital ratio, or CET1 ratio. This reflects how much high-quality, highly liquid capital a bank has relative to a risk-weighted measure of assets -- it's a proxy for leverage.
Banks must maintain a 4.5% CET1 ratio through both stages of the annual tests. In the first stage, known as the Dodd-Frank Act stress tests, or DFAST, the Fed projects what would happen to a bank's CET1 ratio if the economy descends into a deep recession, where the unemployment rate reaches 10% and stock and real estate prices swoon.
The Fed then expands on this in the second stage, the Comprehensive Capital Analysis and Review, or CCAR. This stage incorporates proposals by the participating banks to increase their dividends or share buybacks over the next 12 months. So long as a bank is able to maintain a 4.5% CET1 ratio through both stages, and has a sufficiently sophisticated capital-planning process, it'll get a passing grade.
Here's how the 27 U.S.-based banks fared on the 2017 stress tests:
All of these banks have at least $50 billion worth of assets on their balance sheets, the threshold that triggers their participation in the stress tests. All of them also had enough capital to make it through both stages of the tests while maintaining CET1 ratios above the requisite 4.5%.
The banks that came closest to breaching this were Ally Financial (NYSE: ALLY) and SunTrust Banks (NYSE: STI). In the first stage of the test, Ally Financial's CET1 ratio declined from an initial 9.4% down to 6.5%. This then bottomed out at 5.2% after Ally's proposed capital actions were factored into the analysis. SunTrust Banks, meanwhile, saw its original 9.6% CET1 ratio fall to 5.4% through the two stages.
Most of the other banks that took this year's test emerged with larger margins for error. At the conclusion of the CCAR, the average CET1 ratio among these 27 banks was 6.3%. That represents a meaningful drop from the average 11.2% CET1 ratio at the start of the tests, but the end result is still comfortably above the 4.5% regulatory minimum.
These performances are good news for investors in bank stocks. It means that, unlike the crisis nine years ago, another one in the future is likely to cause much less damage to banks. This should limit the downside risk of owning bank stocks for years, if not decades, ahead.
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