The economic collapse of 2008 showed how closely connected worldwide financial institutions have become. Affected entities included too big to fail financial houses, all the way down to your local bank.
The combination of the failure of the mortgage backed securities market coupled with a liquidity crisis, nearly brought test bank worldwide financial system to its knees. This failure cast light on the risk to the world of finance. Because of government sponsored bailouts, the solvency of large institutions came under scrutiny.
Banks are more responsible for ensuring they have enough capital on hand to absorb problems in the credit market. However, the Federal Reserve wants proof and they use stress testing to obtain it.
Stress testing is now mandated by law, and the operative legislation is the Dodd-Frank Act. Dodd-Frank mandates stress testing for all institutions with at least $10 billion in assets. As a practical matter this now applies to nineteen of the largest US financial houses, including Chase and Morgan Stanley.
A stress test is a balance sheet assessment that looks to an institution’s insolvency under hypothetical unfavorable economic conditions. One example supposed a 21% drop in housing prices, a 50% drop in equity prices, and an unemployment rate of 13%. These conditions are unlikely but may be possible, and are similar to what some would call an economic apocalypse.
While many subject to the stress test passed, for others it was very close, or a small amount failed. Needless to say, confidence was shaken among those who choose to invest in the financial industry, despite the many bailouts and increased scrutiny.
What does this mean for your local bank? Community institutions are exempt from stress testing, but that does not mean they have no responsibility. The Comptroller of the Currency has issued guidelines for institutions with less than 10 billion in assets. Among the areas that are being looked at are commercial real estate borrowing and commercial transactions.
Because of the connection between domestic banks and European banks, stress tests are now mandated for overseas institutions. Stress tests are planned for 124 banks across 22 countries.
For your local bank, a regulator will be looking at toxic assets. These are assets that the regulator may believe to be illiquid and inflated in value. These will primarily deal with loans, and will look at the risk associated with those loans. Next, the regulator will look at uninsured mortgage backed securities. The regulator will discount the value of these assets.
These potential losses are totaled and factored into the adverse scenario, and they will be offset against the institution’s ability to earn its way back to health. If passed, business goes on as usual. If failed, the regulator may require additional capital to be raised. If the capital cannot be raised, closure will be the final step.