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Eurozone Fears Drive U.S. Bank Stress Test

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The Federal Reserve will stress-test the 31 largest U.S. banks, those with at least $50 billion in assets, in an attempt to restore confidence in the country’s banking system, and the six largest must also pass tests of their trading operations.

Bloomberg reported that the tests will use severe scenarios, with parameters such as an unemployment rate of 13%, an 8% fall in GDP and a 52% fall in stocks from Q3 2011 to Q4 2012. In addition, the six banks facing trading tests, according to a Reuters report, will confront price and rate movements that occurred in the second half of 2008, as well as “potential sharp market price movements in European sovereign and financial sectors.” Those banks are Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo.

The Fed said that the tests do not represent its outlook for the economy, but instead are intended to make banks’ capital adequacy more transparent by showing whether they can handle a deeper downturn and financial market shock. Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington, D.C., regulatory research firm whose clients include the largest banks, said of the strategy, “This is a daunting test. The Fed’s credibility as a tough guy can’t be challenged based on this.”

Nancy Bush, a longtime bank analyst and contributing editor at SNL Financial, was quoted saying, “They are clearly worried about the issue of Europe. In a time of risk aversion and concern, you need transparency.”

Tests will be based on bank size and complexity. Each bank must submit its capital plan to the Fed by Feb. 9, 2012; the Fed intends to respond by March 15. At some point the results will be published, although no date was yet available for publication.

The Fed said it will use the stress tests to decide whether banks are strong enough to raise dividends or repurchase stock, or if instead they need to raise capital. It also plans to release more information about the results than it did after previous tests, and added that it is doing so to “foster market discipline.” It intends to disclose the estimate of revenues, losses and capital ratios of the 19 biggest banks if they were to suffer a market shock.

The Comprehensive Capital Analysis and Review is part of the Fed’s heightened oversight of the largest lenders, and complies with the Dodd-Frank act’s requirement for annual stress tests. It also adds its own requirement by asking bank boards to come up with a strategy for capital management over several quarters, with the objective “to ensure that institutions have robust, forward-looking capital planning processes that account for their unique risks, and to help ensure that institutions have sufficient capital to continue operations throughout times of economic and financial stress,” according to a Fed statement.