If you invest in banks, you probably already know that the Federal Reserve releases the results of the 2013 stress tests tomorrow. As I discussed earlier today when noting that Bank of America Corp (NYSE:BAC) will likely pass the test with flying colors, how banks perform during this stage in their annual regulatory cycle largely dictates whether or not they’ll be able to increase the amount of capital they return to shareholders via dividends and/or share buybacks for the remainder of the year. This is why the stress tests are so important.
That being said, with respect to at least some banks, the term “stress test” is a bit of a misnomer. In other words, there’s little question that certain banks will sail through the process without anything to worry about. If the title of this article didn’t already give it away, Wells Fargo & Co (NYSE:WFC), the nation’s fourth largest bank by assets, is one such bank.
A brief introduction to stress tests
As I discussed earlier:
In the wake of the financial crisis, Congress enacted the Dodd-Frank Act, which requires the Federal Reserve to conduct stress tests of banks and other financial concerns with assets in excess of $50 billion. The purpose is to evaluate whether these so-called too-big-to-fail institutions have, as the Fed describes it, “sufficient capital, on a total consolidated basis, to absorb losses as a result of adverse economic conditions.”
The process seeks to simulate the impact on a bank’s regulatory capital levels under three hypothetical and increasingly severe economic scenarios. The most arduous assumes that real GDP declines an average of 4% this year, the unemployment rate ticks up to 12.1% in the second quarter of next year, and that home prices fall by more than 20% by the end of 2014. Suffice it to say, this is an extreme case. As the Fed notes, at least with respect to unemployment, the designated rate remains “above any level experienced over the last 70 years” — that is, since the Great Depression.
When subjected to a similar set of assumptions last year, the vast majority of banks passed the test with ease. In Wells Fargo & Co (NYSE:WFC)’s case, its Tier 1 common capital ratio fell from 9.34% of risk-weighted assets down to 6.6%, well in excess of the required 5% rate. As you can see here, this placed it in the middle of its peer group, or 8th out of the 19 banks tested. While it was the best-performing of the four so-called too-big-to-fail banks, it was beaten out by American Express Company (NYSE:AXP), the custodial banks State Street Corporation (NYSE:STT) and The Bank of New York Mellon Corporation (NYSE:BK), and a smattering of regional lenders including Fifth Third Bancorp (NASDAQ:FITB), U.S. Bancorp (NYSE:USB), and BB&T Corporation (NYSE:BBT). The latter three, for instance, ended up with Tier 1 common capital ratios of 7.7%, 7.7%, and 7.3%, respectively.