How would the U.S. banking and financial system fare if the dark days of 2008 were upon us again? That's the question the Federal Reserve is asking the nation's top bank holding companies (BHCs).
The Fed announced a new round of financial stress tests (officially called the "Comprehensive Capital Analysis and Review) that are intended to gauge the financial stability of the 31 largest U.S. institutions with assets of $50 billion or more. In early 2009, the government demanded similar tests on the 19 BHCs and required those companies that did not "pass," to raise additional capital as a buffer. This time, the Fed has added 12 more institutions. Banks must submit their numbers and plans by Jan. 9, with the results due in March.
The top BHCs must run an analysis factoring in the following variables: U.S. unemployment of 13 percent by early 2013; a 50 percent drop in the stock market; and a 20 percent further decline in home prices.
The most interesting part of the new tests is a new hurdle for the six largest BHCs: Bank of America Corporation, Citigroup Inc., The Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley, and Wells Fargo & Company. The "big six" need to factor in a "hypothetical global market shock" related to the turmoil in Europe and show how they would perform under dire economic circumstances.
In other words, what would happen if it were Lehman all over again? (The Fed notes that banks should calculate losses "based on an instantaneous repricing of trading and private equity positions for the changes in market pricing variables that occurred over the period June 30, 2008, to December 31, 2008.")
The banks that look wobbly -- at this point, it looks like-- may be forced to raise extra dough and could see dividend plans curtailed. Then, at the end of the process, the Federal Reserve will publish the results "to provide insight to market participants into the resiliency of the BHCs very stressful hypothetical environments."
Here's my general take on these tests: They rarely contemplate the real worst-case scenario, which could be playing out in Europe long before the results of the stress tests are in. What stresses me out is that U.S. regulatory reform never addressed the big problem of our banking system: It's still too big and too interconnected for regulators to properly manage and oversee.