Bank of America Corp (BAC) Will Pass the Stress Test With Flying Colors

This is a big week for banks. On Thursday, the Federal Reserve releases the results of the annual stress tests, which ultimately dictate whether or not the nation’s largest financial institutions can increase the amount of capital they return to shareholders via dividends and/or share buybacks.

While the term has become a bit of a misnomer, as there’s no question that most banks will pass at least the first round of examinations — the second round comes next week when the Fed considers capital allocation requests — it’s still a critical stage in the annual rhythm of banks. And none more so than Bank of America Corp (NYSE:BAC).

To get to the point, I believe Bank of America Corp (NYSE:BAC) will not only pass this round of tests, but that it will do so with flying colors. And while that may not surprise you, the reason it will pass so comfortably suggests to me that the nation’s second largest lender will also be given approval next week to increase its quarterly dividend payout.

A brief introduction to stress tests
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.

Facing an analogous scenario last year, Bank of America Corp (NYSE:BAC) passed with a comfortable if not excessive margin of safety. The Fed’s stressed capital projections for the bank estimated a minimum Basel 1 Tier 1 common capital ratio of 5.7% under the most severe adverse economic conditions, exceeding the requisite 5% rate. Nevertheless, as you can see here, that put B of A near the bottom of its peer group, beat out by the likes of Citigroup Inc. (NYSE:C), Wells Fargo & Co. (NYSE:WFC), and JPMorgan Chase & Co. (NYSE:JPM), among others.