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Latest Stress Tests Are Expected to Show Progress at Most Banks

In another milestone in the banking industry’s recovery from the financial crisis, the Federal Reserve this week will release the results of its latest stress tests, which are expected to show broadly improved balance sheets at most institutions.

Keith Brofsky | Photodisc | Getty Images

The findings would be the latest of several signs of renewed strength in the economy, including the unemployment report last Friday that showed that more than 227,000 jobs were created in February.

For the financial sector, including traditional banks and Wall Street firms that were at the heart of the panic during the crisis, the recovery has been slow but steady, with some banks recovering much faster than others.

Still, while unpleasant surprises are possible, analysts are counting on the Fed to find banks largely healthy. That would stand in marked contrast with the holes, in the tens of billions of dollars, found on balance sheetsin the first round of stress tests in 2009.

“Everybody wants to avoid headlines,” said Chris Kotowski, an analyst with Oppenheimer. “People are angry at the banks, and both the banks and the regulators just want to do something to show we’re working our way back towards normalcy. That’s what everyone is craving.”

The examination is not merely an intellectual exercise. If institutions fall short, they could be required to raise billions in new capital, depressing their shares. If they pass, dividend increases and stock buybacks by the strongest institutions will follow as they did after the second round of tests a year ago, pleasing investors whose banks’ stocks still trade at levels far below where they where before the collapse of Lehman Brothersin September 2008.

Under the tests, Federal Reserve specialists are trying to predict how capital levels at the 19 largest banks would withstand an economic downturn even more severe than the one that followed the Lehman collapse.

In addition to a 50 percent stock market decline and an 8 percent contraction in real gross domestic product, the tests envision an unemployment rate of 13 percent, well above the 10.2 percent peak recorded in October 2009. A surge in unemploymentwould increase losses for banks on mortgage and credit card debt.

If all that were not enough, the Federal Reserveis considering what would happen to bank assets if a market shock hit Europe and reverberated in the United States, gauging the extent of losses that have not loomed large for American institutions, despite the continuing problems in Greece and weaker European borrowers.

Regulators are walking a fine line: if they permit the banks to return too much capital now, that might leave the industry vulnerable in the event of a downturn and lead others to think the industry was returning to its risky ways. On the other hand, a raft of negative results would alarm investors just as calm seems to be returning to the markets.

“It’s going to end up being a compromise between regulatory constraints and what the banks desire,” said Kamal Mustafa, chairman and chief executive of Invictus, a consulting firm in New York that focuses on the financial sector.

For banks to pass the tests, they must show that their Tier 1 capital ratio—the strictest measure of a bank’s ability to absorb financial blows—will be at 5 percent or better, even in the Fed’s nightmare case. To raise dividends or buy back stock, the ratio would have to remain above 5 percent, after capital was returned to shareholders.

Tier 1 capital ratios for the 19 largest banks have improved since the depths of the financial crisis, rising to 10.1 percent in the third quarter of 2011 from 5.4 percent in the first quarter of 2009. Actual capital in dollar terms has jumped to $741 billion from $420 billion.

“The industry is on much firmer ground than it was three years ago,” said Jason Goldberg, an analyst for Barclays. “This will show how much progress the banks have made in cleaning up their balance sheets.”

“It was painful to get here in some instances,” he said, referring to institutions like Bank of America and Citigroup that had to sell billions of dollars’ worth of new stock to raise capital, lowering the value of the stock held by shareholders and leaving their shares well below precrisis levels. “But we did get here.”

While Europe’s problems seem to have cooled a bit, and bondholders last week largely accepted a partial write-down on the face value of their debt by Greece, the Europe-oriented part of the stress tests will look at six of the largest American financial institutions—Bank of America, Citigroup, Goldman Sachs, JPMorganChase, Morgan Stanley and Wells Fargo—with a particular focus on their trading desks.

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Unlike the findings of the last round of stress tests, which ended last March, the results of this round will be made public by the Federal Reserve, with an announcement expected by Thursday. Last time, the Fed informed the banks of their results, and it was up to them to announce whether they would proceed with dividend increases or buybacks.

Federal Reserve officials, led by Daniel K. Tarullo, a Fed governor, have pushed to make more information public about underlying conditions, despite opposition from bank executives. In this case, the Fed will release figures like the potential drop in revenues, expected losses, and capital levels in the event of a sharp downturn. Banks will be informed individually of their results before the public disclosure, and will then follow up with any news of dividends or buybacks after the Fed announcement.

Some banks will fare better than others in the tests, according to interviews with analysts, bankers and consultants.

Bank of America, still coping with the effects of billions in soured subprime mortgages, is likely to pass its test but is not seeking to raise its quarterly dividend of 0.01 a share or start new buybacks. With memories still fresh of its near collapse in the financial crisis, Citigroup is likely to be permitted only a small dividend increase, as it slowly streamlines and winds down unprofitable businesses.

Morgan Stanley is not expected to increase its dividend; the investment bank is earmarking capital to buy from Citigroup the part of Morgan Stanley Smith Barney brokerage that it does not own. Analysts said that Goldman Sachs also was not expected to increase its dividend significantly.

On the other hand, stronger banks like JPMorgan Chase and Wells Fargo are expected to score high marks, as are some regional banks, including BB&T , Fifth Third , KeyCorp and M&T Bank . At Barclays , Mr. Goldberg predicted the yield on KeyCorp shares could double to 2.6 percent, from 1.3 percent, while the payout on Wells Fargo could rise to 2.2 percent from 1.5 percent.

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