Each year, the Federal Reserve puts the nation’s biggest banks through stress tests. It wants to make sure they can keep lending even in scenarios where home prices plummet and unemployment spikes. Thirty-one banks passed a round of tests last week.
“The results last week were purely quantitative. How the banks do under each of the scenarios,” says Karen Petrou, managing director with Federal Financial Analytics.
The next round takes a more qualitative look at the individual banks and their capital planning—how they plan to distribute capital to shareholders through, say, dividends, and whether that leaves them with enough of a capital buffer to cover potential losses.
Petrou says some banks might fail this time.
“The Fed looks at the bank and says no, your mortgage loans are a lot riskier than other bank mortgage loans and you should know that,” Petrou says.
The Fed could tell those banks to keep more capital on hand. Duke University law professor Lawrence Baxter says that could mean share buybacks and dividends are forbidden. Stock repurchases benefit stockholders, because they increase the value of an individual share, but they cut into capital.
“The view is that if they don’t maintain sufficient capital to deal with these adverse circumstances, the rest of us are exposed,” he says.
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