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New Details On Govt's "Stress Tests" For Banks

The Federal Reserve has just put out its explanation of how it is conducting the stress test of the country's biggest banks.

The headline is that the 19 banks being tested have been given the preliminary results of their exams. The Fed also revealed that the worst case economic scenario it's using to test the banks is an unemployment rate of 10.3 percent by 2010. The results will be made public on May 4th.

The Supervisory Capital Assessment Program: Design and Implementation
Many analysts say a bank needs at least 3-4 percent of Tier 1 reserve capital to protect itself from loan losses in difficult economic times. Generally Tier 1 capital is a combination of common stock and reserves.

Senior officials at the Federal Reserve would not detail the size of the capital cushion their stress test requires when they spoke with reporters today. They did reveal however, "A vast majority of these firms exceeds the capital they need today."

For the record, most analysts say a bank needs at least 3-4 percent of reserve capital to protect itself from loan losses in difficult economic times.

Bank Analyst Paul Miller and his team at FBR Capital Markets Corporation in Arlington, Virginia have just run a stress test of their own. FBR looked at the nine banks they cover: Wells Fargo, Bank of America, BB&T Corporation, PNC Financial Services, Capital One, Suntrust, US Bancorp, Regions Financial Corporation, and American Express.

FBR Capital Markets' Stress Test Results
What's interesting about FBR's project is that it used a much more dire employment scenario in which to test the banks' ability to withstand further economic turmoil. FBR looked at each bank's capital cushions if unemployment were to rise 10 percent, 12 percent or 14 percent.

According to the FBR test, most of the big banks will be able to earn through a 10 percent unemployment rate. But things get much more tenuous if unemployment is closer to 12 percent, which FBR believes is more realistic.

"The worse the unemployment rate gets, the worse these losses are going to get", says FBR's Paul Miller. "So, when you start getting to 12percent, even most bankers will admit that they are going to be in trouble and will need a lot more capital to make it through this process."

So how did some of the banks do in Miller's test?

Bank of America, Wells Fargo, US Bancorp and BB&T manage to keep their capital cushions well above 4 percent in the 10 percent and 12 percent unemployment scenarios. But if unemployment were to reach 14 percent, all three would be in immediate need of capital.

PNC manages to stay above the 4 percent capital cushion in all three FBR scenarios.

Capital One, Regions Financial Corp, Suntrust dip under that 4 percent cushion in the worst two scenarios.

Only American Express fairs badly under all three scenarios.

Let's see what May 4th brings. Expect a lot of whispers and market volatility in the meantime.

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