Should I care about bank stress tests?

Question: I’ve seen headlines about bank stress tests in the past few weeks. I own a few bank stocks. What does this mean?

Answer: Remember how during the financial crisis many banks were referred to as “too big to fail”? The stress tests are designed to ensure that any bank that is too big to fail doesn’t fail.

The stress tests apply to all banks over a certain size. In 2017 and prior years, the threshold had been $50 billion in assets. Recent rollbacks of banking regulations have increased the threshold to $100 billion for 2018, and this will gradually rise to $250 billion.

The tests are designed to discover what would happen to the largest banks in the event of a severe global recession, defined as negative 7.5 percent GDP growth over seven quarters, 10 percent unemployment, 65 percent drop in stock prices and other conditions.

For investors, the most important thing the stress tests do is determine whether or not each bank’s capital plan is approved by the Federal Reserve. In other words, these large banks (formally referred to as systemically important financial institutions, or SIFIs) need the Fed’s approval before paying dividends or buying back shares with their capital.

While there are minimum capital levels that need to be maintained under adverse conditions, there’s no pass/fail threshold when it comes to the capital plans. In other words, it’s possible for a bank to pass the stress test and still have its capital plan rejected.