The 2018 bank stress tests looked at the capital levels of 35 of the largest U.S. banks during a hypothetical severe global recession.
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This video was recorded on July 2, 2018.
Shannon Jones: When we're looking at the specific financial metrics that the Feds actually reviewed for these banks, Matt, what were they looking at? And, overall for the industry, how exactly did the industry fare?
Matt Frankel: They're looking at four specific capital levels. Without giving you too much of a lesson behind them, they're known as the tier one leverage ratio, common equity tier one ratio, the tier one capital ratio, and the total capital ratio. Depending on which metric you're talking about, you want the number to be somewhere between 4-8%. 8% is the total capital level, which is the big picture. The other definitions have been phased in over the Dodd-Frank reforms coming in to be.
Anyway, long story short, this year, all 35 banks passed the initial stress test, which makes sure that they will have sufficient capital in a severe global recession. This test found that, between all 35 of them, they would lose a total of $578 billion over a nine-quarter recession, which is a lot of money, but it's not enough to put any of them out of business, is the key takeaway here. So, things will get bad, but the banking system would not need a bailout like it did ten years ago.
Jones: Exactly. Key takeaway is, long story short, with all 35 banks passing, this is really good news for the industry and for the economy as a whole. As a matter of fact, the Vice Chairman of the Federal Reserve even went on to say that the capital levels of the firms after this hypothetical severe global recession are actually higher now than what they were looking back pre-recession years. What we have right now is a pretty impressive growth and management of our largest banks. It really speaks to how well-capitalized they are for the future compared to where they were.
With that, Matt, let's talk a little bit about what this means. Why does it even matter for investors?
Frankel: First of all, it's interesting to note that this year's scenario that was tested -- I mentioned the 65% drop in the stock market, and things like that -- was actually worse than it had been in previous years. In other words, the test is getting harder, and all 35 still passed.
What this means for investors, obviously it's a good thing. If the economy was on the verge of collapse again, the banking system would make it. That's definitely good for bank investors. We want to know that they won't need a bailout attached to their money again, which was a big problem.
The second phase of the stress test is to approve the bank's capital plan for the next 12 months. This means how much they're allowed to pay out in dividends, and how much they're allowed to use to buy back stock. This is just for the largest of the large financial institutions. 18 of those 35 banks had to have their capital plans reviewed this year. The Fed wants to know that, even if things went terribly, if the bank wants to spend this much on dividends and this much on buybacks, it would still have a nice cushion if things went poorly.
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