The US Federal Reserve will conduct a stress test for 6 of the largest banks in the country, with the aim to assess the relative health of the banks as well as for the entire financial system in the event of a possible global market shock in the future.
The six banks that have been targeted for the test include the Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo.
As part of the test, the banks will be asked to gauge losses from a "hypothetical global market shock" related to the current turmoil in Europe, said the Federal Reserve on Tuesday.
The Fed added that test "will be based on market price movements seen during the second half of 2008," when financial markets froze following the bankruptcy of Lehman Brothers Holdings Inc.
In the Fed's hypothetical stress scenario, unemployment would spike as high as 13 percent while US GDP would fall by as much as 8 percent. While the numbers appear worrying, the Fed was keen to emphasise that the scenarios were purely hypothetical and “not forecasts”.
This will be the second time that the US Federal Reserve has conducted such a test. According to the Financial Times, the annual “comprehensive capital analysis and review” was designed in the aftermath of the 2008 financial crisis to ensure that US banks were adequately capitalised to weather an economic storm both at home and abroad.
In addition to these 6 banks, 13 more of the nation’s biggest banks will face public disclosure of their estimated capital levels and revenues under the stress scenario. Banks that do poorly on the test, which includes judging on their capital planning and risk management, will be prevented from paying out increased dividends or share buy-backs. According to a statement by the Fed, even healthy banks would “receive particularly close scrutiny” if they propose dividends of more than 30 percent of their net income.
The banks must submit their capital plans to the Federal Reserve by January 9 2012 with a response to the bank expected by March 15 next year. The Fed though did not state when the results would be released to the public.
The switch to public disclosure of the results is also the Fed's way of demonstrating that the US banking system can withstand any turmoil, said analyst Gerard Cassidy of RBC Capital Markets to the Wall Street Journal. The hope is "investors will say, 'Wow the U.S. banking systems can handle these shocks very well,'" added Cassidy.
According to the Federal Reserve’s governor Daniel Tarullo, the goal for making the tests more transparent and open to the public is to release "this kind of standardized, comparable information on a regular basis so that it's not a momentous event."