Surprise! Your Bank Just Failed the Stress Test

Good news! The Federal Reserve just ran its third round of "stress tests," checking up on the fiscal health of America's biggest banks. Most banks passed ... but not all.

Out of 19 big financial institutions put through the wringer, 15 passed with flying colors. Indeed, bankers Wells Fargo, U.S. Bancorp, BB&T, American Express, KeyCorp, PNC, Morgan Stanley, Goldman Sachs, and Bank of New York Mellon were found to be so flush with cash that the Fed granted them permission to spend their extra loot on boosting dividends to shareholders and buying back shares (which boosts earnings per share for these same shareholders).

Not everyone was so lucky. According to the Fed, four bank holding companies -- Ally (the former General Motors credit arm), Citigroup, Suntrust, and MetLife -- were all found to have insufficient capital reserves to survive a Cat-5 economic storm. None of these four bankers will be permitted to repurchase shares or boost dividends.

Teaching to the test
As you may recall, much mockery was made of a similar round of stress tests that European financial regulators conducted last year. The European Banking Authority proudly announced that 91% of the 90 banks tested were sufficiently sound to survive a 0.5% wobble in GDP, coupled with a 15% slide in stock markets.

The Euro-banks' 91% pass rate may sound better than the 79% that American banks just scored. But U.S. investors, and depositors, shouldn't necessarily worry about that. Our test was much harder to pass, modeling for

  • a 21% drop in home prices, which would devastate the value of banks' mortgage portfolios;
  • 13% peak unemployment,  which would dry up the loan market, and drain capital from bank accounts as depositors are forced to live off their savings;
  • and $534 billion in total banking losses over the course of two years.

In fact, the American Bankers Association complained that even more of its members should have passed the test. According to the ABA, the Fed's hypothetical scenarios were actually worse than anything U.S. banks faced in the 2008 Financial Crisis.

What does this mean to you?
All's well that ends well, yes? Nothing to worry about here, right? Well, that depends on who you're talking about. Bank depositors can take comfort in the fact that the Fed conducted a real test of the stress that a major economic crisis would inflict on the U.S. banking system. They can also rest assured that the majority of U.S. banks passed the test, and that the Fed is on the alert, knowing "who is the weakest link," and intending to get these links strengthened.

This, combined with the knowledge that the Federal Deposit Insurance Corporation is still promising to make depositors whole in the event of a banking failure (so long as you have no more than $250,000 deposited in an FDIC-insured account), should reassure depositors that their money is safe.

If you're an investor in banking stocks, though, don't get overconfident.  The Fed is on the ball, yes: It's running stress tests annually, and doing its darnedest to make sure we don't see another major bank fail and go bankrupt, a la Lehman Brothers in 2008. But that's only a partial guarantee.

Remember that even though it was among the big banks that survived the last financial crisis, Citigroup still managed to lose 98% of its market cap between October 1, 2007 and the crisis nadir on March 2, 2009. Bank of America, which passed this round of stress tests, lost 94% in the last crisis. Even Wells Fargo, Warren Buffett's favorite bank, lost 77%.

This week's stress test results tell you that, in the Fed's opinion, even if Financial Armageddon strikes, 15 out of 19 major U.S. banks are not at risk of failing and taking 100% of your investment down with them. But when it comes to the possibility of a mere 98% loss, there's still no guarantees. Caveat investor.

At the time this article was published Motley Fool contributorRich Smithdoes not own shares of any companies named above. The Motley Fool owns shares of Bank of America, Wells Fargo, Key, Citigroup, and PNC Financial Services Group. The Fool owns shares of and has created a covered strangle position in Wells Fargo.Motley Fool newsletter serviceshave recommended buying shares of The Goldman Sachs Group and General Motors; and creating a write covered strangle position in American Express.

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