What Are the Bank Stress Tests?

The 2018 bank "stress test" results were just announced by the Federal Reserve.

In this clip, Industry Focus: Financials host Shannon Jones and Fool.com contributor Matt Frankel discuss what the stress tests are and which banks they apply to.

A full transcript follows the video.

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This video was recorded on July 2, 2018.

Shannon Jones: Before we dive into the actual results of the stress tests, let's just set the stage. Let's talk about, what exactly is a stress test, and more importantly, why is it even done in the first place?

Matt Frankel: First, the important thing is who this actually applies to. This only applies to the biggest banks in the U.S. If you see your local credit union or regional bank, chances are they're not subject to the stress tests. These are part of the Dodd-Frank financial reforms that were enacted after the financial crisis. They're basically designed to ensure that the banks that are too big to fail aren't in a position where they could fail.

Basically, it established the definition of what we refer to as a SIFI, which stands for systemically important financial institution. These are the biggest banks in the country. The threshold for years has been set at $50 billion in total assets. The recent banking regulation rollbacks that we referred to in the previous episode raised that to $100 billion this year, and it's going to gradually increase until it gets to $250 billion. This is going to increasingly apply to even bigger and bigger financial institutions only. This year, there were 35 banks in all that it applied to.

So, what is the stress test? Basically, the stress test sees what would happen to a bank in a worst-case scenario, a severe global recession. These are hypothetical tests designed to see what would happen if the economy got really, really bad. To give you the statistics of what they're looking at this year, the hypothetical scenario is negative 7.5% GDP growth, 10% unemployment, 65% crash in the stock market, 30% drop in housing prices, and a few other factors. Just to put that in perspective, the financial crisis in 2008 led to the Great Recession, where we saw GDP contraction of about 3.5%. Unemployment did get to 10%. The stock market, from peak to bottom, fell about 57%. In other words, this is a scenario that's even worse than the Great Recession, a really bad scenario. They want to make sure that banks have enough capital to make it through a situation like that.

Jones: Absolutely. The overarching goal of these stress tests is really to ensure that we never get to that place again.

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