It is testing time for America’s big banks.
In the past week, the Federal Reserve released its annual review of the soundness of the American banking system. (As a group, they passed.) In the week ahead, it will unveil if those individual banks can send more money back to shareholders. If the Fed thinks the banks do not pose a big risk to the economy (read: would need a taxpayer bailout). Next week bank stock investors will learn if they can get paid.
The idea to put big U.S. banks through a battery of economic and financial bad-to-worst case scenarios is a result of the near collapse of the banking system during the Great Recession. If you need a reminder about the risks banks pose to an economy, just witness Friday’s reaction to the Brexit vote in the U.K. The U.S. financial sector was the hardest hit after U.K. voters decided to leave the European Union. Even the American Federal Reserve was compelled to put out a statement, reminding global investors it is on alert to loan money to other central banks if they are pinched for cash.
The Fed’s stress tests examines how the 33 biggest banks in America would be impacted if the economy turns sour, unemployment jumps to 10 percent, stock prices are cut in half and interest rates go negative. Regrettably, it didn’t ask what would happen if voters in a major global economic power decide to leave one of the largest trading unions in the world.
Banks have to hold back capital (cash, high quality bonds they can quickly sell for cash) in case of financial emergencies and the people they lend money to can’t pay them back. For instance, think of a homeowner not paying his or her mortgage. If a bank has more of a financial cushion than the Fed requires, the bank can pay shareholder dividends or use the extra money to buy back stock, also helping shareholders. That’s the decision due on Wednesday.
As banks have gotten bigger, so have the risks they hope to manage. As the chief regulator for banks, it's important for the Federal Reserve to conduct these annual exams measure how the banks could withstand tough economic times. However, every parent and teacher knows, tests only measure what’s asked. And economies (and their voters) rarely behave as they’re asked, as investors have learned again in the past week.
Financial journalist Tom Hudson hosts The Sunshine Economy on WLRN-FM in Miami. Follow him on Twitter@HudsonsView.