Shares of large US banks had jumped higher on Thursday when for the first time all major US banks passed the Fed’s stress tests.
In addition, the Federal Reserve had announced its approval of the capital plans for 34 banks in the United States in the second round of financial stress tests, this was the first time in seven years it had passed without any objection.
What are Banks Stress Tests?
A financial stress test is used to determine a bank’s future risk tolerance by playing out possible scenarios that banks can face. Different scenario levels are set, such as the expected scenario, the current situation and the worst scenario.
These tests measure a bank’s capacity to cope with the various scenarios, ensuring a bank’s ability to endure the worst scenario, and measure the capital resources that help the bank overcome these potential downturns.
The Importance of Stress Tests
The importance of stress tests is that they can help banks and financial entities to take the necessary steps against various scenarios, and ensure that the government has a plan to provide the necessary financial support in case of the worst scenario, so the bank can continue its operations without being exposed to bankruptcy.
Hence, the result of the tests determines the powerful banks that can deal with any volatility and crises, and identifies banks that are likely to need assistance to be able to overcome a negative scenario.
Genesis of Banks Stress Tests
At the beginning of his presidential mandate, Barack Obama had announced that he will subject American banks to stress tests to determine their real ability to bear a potential crisis.
19 banks were subjected to these tests by the Federal Reserve. The results were announced to the public to reassure markets about status of US banks in global markets.
Earlier, the European Central Bank had conducted these tests on EU banks in 2009, but not all banks were included. Instead, a sample of 26 banks was chosen, and then 91 banks were subjected to these tests, which accounted for 65% of the total European market.
Characteristics of the Worst Scenario
Attributes of the worst scenario are used to determine the capacity of banks to weather a shock in growth rates, which will result a decline in GDP rates and consequently increase the unemployment rate and decrease the level of confidence in the economy.
Financial Stress Test Process
At the beginning, the capital percentage to total assets is calculated according to the main expected scenario. Then, the ratio of capital to assets is calculated according to the worst scenario, which includes growth shock and sovereign debt. After that, the ratio of capital to assets is compared. If the ratio is 6% or more, the bank has successfully passed the test. If it is less than this percentage, the bank has failed in the test and must manage financial resources to raise its capital to assets ratio.
6% was used as a benchmark because the European banks are subjected to a minimum capital to asset ratio of 4%.