Under the Dodd-Frank Act, the Federal Reserve is required to conduct stress tests which are forward-looking exercises to determine whether large institutions have sufficient capital to absorb large losses and support operations under severely adverse economic conditions.
The supervisory stress tests include examining capital ratios, revenue and the size of potential losses. The Federal Reserve will release the results of the stress tests on March 7, 2013. The related results from the Comprehensive Capital Analysis and Review (CCAR) will be released a week later on March 14, 2013.
The Federal Reserve conducts the CCAR annually, in which they assess whether the “too big to fail” banks have amassed sufficient capital to continue normal operations over the next two years despite “economic and financial stress.” The forward looking tests of capital adequacy take into account each bank’s unique risks in conjunction with the bank’s own risk measurement and management practices. The capital ratio tests conducted under the CCAR reflect not only the Fed’s “severely adverse scenario” but also the action plan of each bank to maintain adequate capital under such future circumstances.
Using the results of the CCAR testing, the Federal Reserve will evaluate each financial institution’s plan for capital distributions such as dividend payments, stock buybacks or potential acquisitions.
Despite the formidable series of tests being conducted under the Dodd-Frank Act, it is highly likely that none of the countries largest banks will wind up publicly “failing” the stress tests. Last year some banks (including Bank of America) failed the stress tests based on planned dividend and stock repurchase plans, which was publicly embarrassing. This year, according to the Wall Street Journal, the Fed will allow banks to alter capital distribution plans prior to the release of stress test results if they exceed levels deemed appropriate by the Fed. This is somewhat akin to allowing students to grade their own exam papers. The really big shock would be if any systemically important institution winds up failing the stress tests.
In addition, Warren Buffett, one of the largest bank investors in the country and with close ties to the Obama administration recently came out with a ringing endorsement of the nation’s largest banks. According to Buffett, “The banks will not get this country in trouble, I guarantee it. The capital ratios are huge, the excesses on the asset side have been largely cleared out.”
Continuing to talk his own book, Buffett also proclaimed that “Our banking system is in the best shape in recent memory.” Buffett, probably the shrewdest investor ever, has made billions by investing in Bank of America, Wells Fargo and Goldman Sachs.
Bank of America gave Buffett 10 year warrants on 700 million shares with an exercise price of $7.15, a position on which Buffett already has over a $3 billion profit. Regarding the stock warrants, Buffett said “We’re in no hurry (to exercise them). Nine years from now I would think that Bank of America as well as Wells Fargo and probably the other major banks will be worth considerably more money than they are now.”