A stress test is the Federal Reserve imagining terrible things and seeing if banks survive.
Things like the “stock market falls 50 percent, housing prices fall 20 percent, and the unemployment rate goes back up to 12 percent” says Rebel Cole. He's a former Fed economist and a professor of finance at DePaul University who trains the International Monetary Fund on how to run stress tests.
Cole doesn’t expect any surprises in today’s Fed results:
“In practice the stress tests aren’t very stressful. The last thing regulators want is to spook the markets. This is about engendering confidence in the banking system" and letting people know that regulators aren't asleep at the helm.
Still, the Fed could be nervous enough to tell some banks to hang on to their cash, and not to give too much to shareholders as dividends or by buying back shares. That part of the stress test won't be made public today.
Anat Admati, a professor at Stanford’s Graduate School of Business, is concerned the banks will get off easy.
“When a company pays dividends or buys back some of its shares, then it doesn’t have that money to invest or back up its debts,” Admati explains, adding that she expects the banks to be allowed to pay out tens of billions of dollars.
Admati says it's in the banks interest to be as indebted as possible -- borrow money when the rates are good, invest it, and reap the majority of the profits for shareholders. Taken too far, that makes banks vulnerable to losses.
Cole says it doesn't make sense for banks feel the need to shovel out cash. A bank's performance is evaluated primarily on its return on equity.
"This doesn't happen in any industry I know of, we usually look at free cash flow, stock prices, but in banking, analysts look at return on equity," he says.
The easiest way to raise your return on equity, Cole and Admati both point out, is to increase your leverage -- to borrow more.
Shareholders will have to wait a week to see whether the Fed lets banks pay higher dividends and which banks it allows to do so.