(Reuters) - The U.S. Federal Reserve plans to stress test six large U.S. banks against a hypothetical market shock, including a deterioration of the European debt crisis, as part of an annual review of bank health.
The Fed said it will publish next year the results of the tests for six banks that have large trading operations: Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo.
“They are clearly worried about the issue of Europe,” said Nancy Bush, a longtime bank analyst and contributing editor at SNL Financial. “In a time of risk aversion and concern, you need transparency.”
The Fed said its global market shock test for those banks will be generally based on price and rate movements that occurred in the second half of 2008, and also on “potential sharp market price movements in European sovereign and financial sectors.”
In the Fed’s hypothetical stress scenario, unemployment would spike as high as 13 percent while U.S. gross domestic product would fall by as much as 8 percent.
The heightened stress tests are part of a larger supervisory test the Fed will conduct on the capital plans of 19 firms with at least $50 billion in assets, including those six large banks.
In addition, the Fed will conduct a scaled-back test on the capital plans of 12 more financial firms considered less complex.
The Fed will use the review of bank’s capital plans to determine whether the banks are robust enough to raise dividends or repurchase stock, or whether they need to obtain additional capital.
The Fed plans to release more information than it did last year about the tests’ results. The regulator said it is doing so to “foster market discipline.”
The Fed said it will disclose the estimate of revenues, losses and capital ratios of the 19 biggest banks if they were to suffer a market shock.
This type of disclosure could give investors and markets more certainty about the strength of U.S. banks at a time when there are deep concerns about their European counterparts.
“Eventually, this will be viewed as a positive, and a lot of people will focus on this as a way to verify the viability of these companies,” said Matt McCormick, portfolio manager at Bahl & Gaynor investment counsel in Cincinnati.
The banks must submit their capital plans by January 9, 2012. The Fed said that it plans to respond to banks by March 15. It was not clear when the results would be published.
Banks have been eager to boost dividends and buy back stock, but the Fed has indicated it will take a tough stance, particularly if a bank is not far along in meeting new international Basel capital standards.
In a November 9 speech, Fed Governor Daniel Tarullo said the central bank would be “comfortable with proposed capital distributions” only when it is “convinced” a bank is on a path to easily meet the new standards.
“I don’t think anyone could say that this is anything but an extremely stringent stress test,” said Karen Petrou, managing partner of Federal Financial Analytics. “It will really put the burden on the affected bank holding companies to prove they can make a capital distribution, not on the Fed to block it.”
The Fed is putting in place a broad stress testing regime in the wake of the 2007-2009 financial crisis when taxpayers were forced to extend a $700 billion bailout to the financial system.
This will be the second round of Fed tests of banks’ capital plans.
Earlier this year, the Fed rejected Bank of America’s plan to boost its dividend in the second half of 2011, while allowing other big banks to move ahead with dividend hikes.
Under the 2010 Dodd-Frank financial oversight law, the Fed is required to conduct stress tests on banks with more than $50 billion in assets.
The latest capital tests are separate from this requirement but the Fed on Tuesday said it would try to harmonize the different testing regimes facing banks.
The expansion of the capital tests beyond the 19 who have been scrutinized in the past will likely not be welcomed by those being added to the list.
“It’s another layer of Fed oversight on their capital, and they’ve fought tooth and nail not to be included in this,” said Paul Miller, analyst at FBR Capital Markets. “So I don’t think any of those banks are particularly happy right now.”
Reporting by Karey Wutkowski, Dave Clarke and Alexandra Alper in Washington, Joe Rauch and Rick Rothacker in Charlotte, and Lauren Tara LaCapra and David Henry in New York; Editing by Bernard Orr and Tim Dobbyn