Bank Stress Tests: CNBC Explains

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Bank stress tests may sound like a wellness program for the financial crowd—and in a way they are. But instead of examining workers' health, it's the banks' books that are under a microscope.

The technical definition is that stress tests are an "analysis conducted under unfavorable economic scenarios which is designed to determine whether a bank has enough capital to withstand the impact of adverse developments."

In other words, the idea is to check if a bank or financial institution has enough money and/or assets on hand to withstand a severe economic crisis, like the Great Recession of 2007-2009, and that its cash reserves don't sink to dangerous levels and lead to a collapse.

The overall idea of the tests is to detect weak spots in the banking system at an early stage, so that preventive action can be taken by the banks and regulators.

That usually means the banks must come up with immediate plans for having enough cash reserves, and that can include restrictions on future dividend hikes to their shareholders or buying back their own stocks.

Guidelines on testing can vary. For instance, the tests conducted by the Federal Reserve in 2012 were aimed at banks with more than $10 billion in assets. They determined the amount the banks had to have in reserve, based on what each bank had in outstanding debts and assets.

Banks or financial institutions with less than $10 billion were urged to adopt a stress test method that fits their "unique business strategy, size, products, sophistication, and overall risk profile," according to the Office of the Comptroller of the Currency (OCC).

Simply put, they could come up with their own testing.

But in 2011, the Federal Reserve Board finalized a rule that bank holding companies with assets of $50 billion or more must submit annual capital plans—or how much reserves they would have if an economic crisis occurred.

Who does the testing?

Until 2007, stress tests were mostly done internally by banks as part of their own risk management. And they can still do so.

When they are on their own, each bank is supposed to come up with its plan that addresses a specific scenario considered particularly damaging for that bank. The Fed has examiners to review and approve this scenario.

But now, agencies like the Federal Reserve or the OCC can originate them. The Fed started special stress tests of banks in 2009 due to the financial crisis. This was mandated by the Dodd-Frank financial reform bill.

That's when the tests got a lot of press, as several banks and financial institutions were deemed severely under-capitalized.

Stress tests focus on a few key risks—such as credit risk, market risk and liquidity risk—to a banks' financial health in crisis situations.

Some banks had to increase their capital levels, but the tests were seen as a key step in rebuilding confidence in the U.S. financial system.

The results of stress tests depend on the assumptions made in various economic scenarios, which are described as "unlikely but plausible." As it turned out, the unlikely happened in 2007 through 2009, as we now know.

Federal stress tests are not conducted every year—there were none in 2010—but they are done in many countries.

Have banks or financial institutions failed stress tests?

Indeed. Results in March 2012 of the biggest U.S. banks showed that four of 19 major institutions failed—Citigroup, Ally Financial, MetLife and SunTrust. (MetLife was not be part of tests in 2013 because it has sold off banking operations.)

Those that had enough reserves included JPMorgan, Goldman Sachs and Wells Fargo.