What to Watch for in Fed's Stress Tests of Big Banks

Big banks will get a peek over the next two weeks into how federal regulators judge them: whether they are deemed safe enough to endure a severe downturn, and whether they have demonstrated enough prudence this year to raise shareholder dividends.

On Thursday, the Federal Reserve will release round one of its annual "stress tests," which rely on hypothetical scenarios. The more important day is next Wednesday, when the Fed releases the full results of the tests, including any capital restrictions. Investors will care more about the second round of test results because those will ultimately determine whether a bank can increase its payout to shareholders.

The Fed is running this version of the stress tests for the sixth time, but each year the parameters shift slightly, so last year's results are no guarantee of performing similarly this year.

Banks spend millions of dollars and hire thousands of people to meet compliance efforts meant to pass the stress tests, but success can sometimes be elusive if they misunderstand the Fed's latest set of expectations -- and the process can be all the more surprising when supervisors no longer find a bank's previously approved process adequate.

It becomes imperative to know: "Will the Fed raise the bar on practices they found OK last year but won't this year?" said David Wright, a former Fed official and now a managing director at consulting firm Deloitte & Touche LLP's banking and securities regulatory practice.

The Fed is assessing 33 institutions this year -- up from 31 last year -- both U.S.-based banks and the U.S. units of big global banks.

Among the big questions this year will be the performance of the newcomers -- TD Bank, the U.S. unit of Canada's Toronto-Dominion Bank, and Bank of the West, owned by France's BNP Paribas SA -- and how other foreign-owned banks will fare.

Foreign banks have struggled to meet U.S. regulators' expectations for risk management. Two large European banks, Deutsche Bank AG and Banco Santander, were the only two to fail last year's stress tests, over shortcomings in how they measured and predicted potential losses and risks. Bank of America Corp. didn't fail but was asked to revise its capital plan before being allowed to issue a dividend to shareholders; 29 banks passed.

The central bank has said it designed the tests to force banks to adjust to a shifting regulatory environment to minimize any chance of their complacency and to protect against potential financial shocks, while encouraging them to improve their data, models, and risk management capability.

Many bank executives consider stress tests something of a black box -- intentionally constructed by the Fed to keep banks from trying to game them. And while regulators strive to better set expectations, some in the industry still criticize the opaqueness and credibility of the Fed's models.

U.S. regulators have sought to make the process more transparent, providing additional guidance while also maintaining a dialogue over the course of the year rather than packing the entire process into a six-week period, potentially minimizing any uncertainty.

"The Fed would prefer the firms not simply try to check the box for having met regulatory expectations, but rather have broader improvements in their capital planning capabilities," said Mike Alix, a partner at consulting firm PwC and a former official at the Federal Reserve Bank of New York, where he oversaw stress tests and capital planning. "There needs to be continuous improvement -- no firm should rest on its laurels."

There have been cases in the past where banks passed the Fed's stress tests and then later failed. HSBC North America Holdings and RBS Citizens Financial Group passed in 2013, but were rejected the following year.

"Every year when the yard stick comes out [the question] is: Are people continuing on the glide path, or did they stall in some areas along the way that are significant enough that their plan needs to be adjusted?" Mr. Wright said.

The stress tests examine two critical aspects of the largest financial institutions. First, whether banks hold enough capital -- money raised from investors or earned through profit -- to withstand severe economic stress in the financial system. And second, whether banks have the appropriate internal processes to identify and measure risk when considering their own capital planning. The Fed can reject a bank's plan to pay out shareholders on either basis.

The initial results on Thursday will show the capital levels of the firms during a hypothetical severe economic downturn, including a 10% unemployment rate and a negative yield for U.S. Treasurys. These will exclude banks' actual plans to offer shareholders dividends or stock buybacks. Rather, they will show the impact of severe stress on banks' revenue and total loan losses from mortgages and credit cards. Thursday's results also won't draw any conclusions on whether a bank will be barred from digging into its own capital to pay out profits to shareholders through dividends or stock buybacks.

Next week, banks will be tested using the same scenarios, only this time institutions' actual capital distributions will be included in the exercise, providing a fuller picture.

The eight largest U.S. banks undertake an additional step by calculating the impact of a default by their single largest counterparty on their balance sheets. Those same institutions, most of which have extensive trading operations will run an additional global market shock when vetting if they hold enough loss-absorbing capital.

Banks will have the opportunity to save face in the coming days. Institutions can make a one-time adjustment to their capital plans if they learn from regulators that they fall below the minimum thresholds after the first round. The so-called mulligan taken by banks to scale back their capital plans will be disclosed as part of next week's stress-test results.

The Fed is considering making changes to the annual exercise to lessen the burden on midsize traditional banks with assets between $50 billion and $250 billion, while simultaneously making the central bank's stress tests tougher for the eight largest U.S. firms.

Write to Donna Borak at donna.borak@wsj.com