Economy Education Policy

Intro to Bank Stress Tests

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A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.

Mark Twain

Ever since the 2008 financial crisis, US banks have been under a great deal of scrutiny. Whether it was providing mortgages to risky borrowers or creating risky products such as CDOs (Collateralized Debt Obligations), these bad practices led to one of the most severe economic recessions in US history. The US government bailed out industry giants such as Goldman Sachs and AIG. In addition, many other businesses such as Lehman Brothers went bankrupt.

After the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act to reform the financial industry. This law brought several changes such as creating the Consumer Financial Protection Bureau (CFPB) and having the Federal Reserve perform bank stress tests to ensure that the largest banks in the US are financially sound. Recently, the Federal Reserve released the results of the latest bank stress tests. Let’s take a look at bank stress tests. 

The Basics

Bank stress tests are used by the Federal Reserve to help determine which banks have enough capital to survive through catastrophic events. An example of a catastrophic event would be an economic recession. The Federal Reserve uses the results of these bank stress tests to ensure that banks can continue to lend to both individuals and businesses during difficult times.

Many large US banks such as JP Morgan and Wells Fargo are required to undergo these stress tests before they can repurchase shares and pay dividends. When a company repurchases its shares, it decreases the number of shares outstanding and increases the company’s earnings per share.

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JPMorgan Chase is required to undergo the bank stress test by the Federal Reserve.

US Banks’ Performance on Stress Tests

In late June 2020, the Federal Reserve started releasing the results of its latest bank stress tests. 

One of the most notable things about the recent stress tests is that the banks are prohibited from repurchasing their shares and increasing their dividends for the 3rd quarter in 2020. This led struggling Wells Fargo to cut their dividend from $0.51 per share to $0.10 per share. Many of the biggest banks such as JP Morgan were determined to have enough capital to survive the coronavirus crisis. However, the Federal Reserve warned that banks could face financial difficulty if the US economy is still in a recession.

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Randal Quarles, Vice Chair for Supervision of the Federal Reserves which runs the bank stress tests. 

The Bottom Line

The Federal Reserve’s bank stress tests are one of many regulations that large financial institutions have to comply with. Bank stress tests help ensure that the largest US financial institutions have adequate financial reserves during difficult times. However, they can also be a burden on many small and local community banks. As a result, the Trump administration has rolled back some parts of the Dodd-Frank Act. However, the bank stress tests are still an important tool to determine which banks are financially healthy. 

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I am an incoming freshman at UCSD and I cover stocks, education, and the economy!

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