By Dave Clarke and Joe Rauch
WASHINGTON/CHARLOTTE, North Carolina (Reuters) - The Federal Reserve will subject more banks to annual stress tests to determine whether they have enough capital and can raise their dividends.
On Friday, the Fed said it is proposing that banks with $50 billion or more in assets be subjected to the capital testing regime, bringing the number of banks that would face annual tests, if they were conducted today, to 35 from a prior level of 19.
The tests seek to determine how a large bank whose failure could hurt the economy and markets would weather a financial shock or an economic downturn.
"Institutions would be expected to have credible plans to have sufficient capital so that they can continue to lend to households and businesses, even under adverse conditions," the Fed said in a release.
Bank stocks, already under pressure, finished the day down 0.4 percent on Friday after being down by about 2 percent earlier in the day, as measured by the KBW Bank Index of large-cap financials. Some of the biggest decliners were regional bank stocks that are now going to face annual tests.
The test has real consequences for banks and their investors.
"It's an incremental negative that makes it easier to be negative and sell any financial stocks right now," Michael James, a senior trader at regional investment bank Wedbush Morgan in Los Angeles, said in reference to the Fed proposal. "The financial stocks have been a big weight and an underperformer all year, so the path of least resistance in the financials continues to be lower, and this won't help that."
Frederick Cannon, bank analyst at Keefe, Bruyette & Woods, wrote in a note to clients that the Fed proposal should not have a big impact on the banks that will now be subject to the capital tests.
He said these banks have been expecting their capital to come under greater scrutiny from regulators and the impact of the tests "should be limited and may only cause small delays of capital deployment if planned for the near term."
The biggest challenge facing the new banks on the capital test list is they have different business models than the largest institutions and will have fewer ways to raise capital if the Fed says they need to do so, some analysts said.
"These banks don't have investment banking or capital markets for growth to fall back on," said Matt McCormick, portfolio manager at Bahl & Gaynor Investment Counsel Inc. "A lot of these guys have big real estate and commercial real estate exposures. This is going to make loan growth very difficult, not be a catalyst for it."
Determining exactly how the Fed capital tests will impact individual banks can be hard to gauge because the agency does not release specifics about how the tests are conducted or the results, said Christopher Whalen, senior vice president and managing director at research firm Institutional Risk Analytics.
"They have been completely opaque and there is no way of benchmarking or verifying what anyone is doing," he said.
During the 2007-2009 financial crisis, the government was forced to extend substantial support to banks such as Citigroup Inc, and the tests are one of several measures taken by regulators to help prevent the United States from having to make future bailouts.
The new Dodd-Frank law requires a set of stress tests for banks, some performed by banks and others directly by regulators, to ensure they can survive a steep downturn in financial markets.
The Fed said the expanded capital tests are intended to complement the stress tests required by Dodd-Frank.
The amount of information banks would have to provide the Fed for the capital tests would depend on the size and complexity of the institution, the Fed said.
The rule is expected to be finalized later this year and the new round of reviews is planned for early 2012.
The proposal will be out for comment through August 5.
(Reporting by Dave Clarke in Washington and Joe Rauch in Charlotte, North Carolina; additional reporting by Dan Wilchins in New York; editing by Gerald E. McCormick, Andre Grenon, Gary Hill)