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Bank Stress Tests Are Cruel, but Fair: Street Whispers

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For its next round of stress tests for the 19 largest US bank holding companies, the Federal Reserve has introduced some new twists, but has also thrown a gift to the banks that may face rejection of their initial plans to return capital to investors.

Companies that had their initial 2012 capital plans in March rejected in full or in part, including Citigroup (NYSE:C), SunTrust (NYSE:STI), and Fifth Third Bancorp (NASDAQ:FITB), had to wait until August for their revised capital plans to be approved. Of the three, only Fifth Third was approved in August for a dividend boost. Neither Citi nor SunTrust requested a dividend increase or share buybacks in their revised 2012 capital plans.

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During the next round of stress tests, banks with capital plans rejected by the Federal Reserve will receive feedback during the stress test process and can lower their capital return plans before the Fed approves or rejects the capital plans, increasing the chances of modest -- or better -- returns of capital to investors.

According to Credit Suisse analyst Craig Seigenthaler, this "one-time adjustment" option will enable banks whose initial 2012 capital returns were rejected, as well as banks like Regions Financial (NYSE:RF) and Zions Bancorporation (NYSE:ZB-PC) -- both of which, in 2012, repaid government bailout funds received in 2008 through the Troubled Assets Relief Program or TARP -- to present more aggressive plans to return capital during 2013 than previously expected.

For the 2012 stress tests conducted during the first quarter, the Federal Reserve used an "Adverse Scenario" that included real US GDP contracting "sharply through late 2012, with the unemployment rate reaching a peak of just over 13% in mid-2013," while also assuming "that US equity prices [fell] by 50% from their Q3 2011 values through late 2012 and that US house prices fall by more than 20% through the end of 2013." In addition, "foreign real GDP growth [was] also assumed to contract, with growth slowdowns in Europe and Asia in 2012."

In order to have their capital plans approved, the banks subjected to the stress tests had to show that their estimated Tier 1 capital ratios at the end of 2013 would remain above 5%, "with all proposed capital actions through Q4 2013."

For the next round of stress tests, the Fed requires bank holding companies to show that they can maintain a "Tier 1 common ratio of 5% on a pro forma basis under expected and stressful conditions throughout the planning horizon," which includes a far less severe Adverse Scenario than the previous round of stress tests, but also includes a new "Severely Adverse Scenario."

Adverse Scenario

The 2013 adverse scenario "features a moderate recession in the United States that begins in the fourth quarter of 2012 and lasts until early 2014; during this period, the level of real GDP declines 2%, and the unemployment rate rises to 9.75%." The adverse scenario also includes CPI inflation rising to 4% and equity prices dropping by 25% through the middle of 2013, with home prices declining "more than 6% during 2013, and commercial real estate prices falling 4.5% during 2013."
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