Banks Face New Stress Tests as Interest Rates Rise

old key sitting on pile of moneyCome September, the American public will get the inside scoop from the nation’s 18 largest banks as to how they’d handle an upset to the apple cart. The Federal Reserve has required the financial institutions to carefully consider how events such as another economic downturn or spike in interest rates would affect their operations. The deadline for their responses was July 5th and their predictions will be made public sometime in September of 2013.

In March, the Federal Reserve released its own “stress test” results. The Fed projected that if the U.S. economy undergoes a recession like the one it’s just climbing out of, those 18 heavy hitting banks would lose $462 billion. In spite of such a large loss, the Federal Reserve governor, Daniel Tarullo stated, “Even with the possibility of losing half a trillion dollars, the country’s 18 largest banks could survive a severe economic meltdown.”

It is important to note that the “stress tests” the banks are completing are separate from the Fed’s assessment process. After the banks have submitted their results, executives are set to meet in mid-July with Fed officials in Boston. The objective will be to discuss how the banks arrived at their conclusions and compare their procedure to the Fed’s. The Fed has been criticized for its failure to reveal the procedure it uses to determine the loss estimates. Last year, when the Fed leaders and bank executives were together for a similar meeting, Paul Ackerman of Wells Fargo, received a round of applause from his peers when he questioned how the Fed comes up with its stress test figures.

The July meeting is set to review topics such as residential and corporate loans, plus how a bank would deal with “counterparty credit risk.” In a counterparty relationship, a financial institution serves as the guarantor of loans. Other topics likely to come up are the dramatic turnaround on refinancing and rising interest rates. As reported by Fortune, the Mortgage Bankers Association confirms that during the first week of June, “borrowers filing refinance applications fell 15 percent.” That marked the third consecutive week for such activity, and was the first to take place during all of 2013.

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This trend goes hand in hand with the fact that interest rates are going up. Homeowners are finding refinancing less appealing and taking a “wait and see” stance. It is worth noting that a drop in interest rates was only just included as one of the stress test factors on the Federal Reserve’s analysis process. However, the Office of the Comptroller of the Currency or OCC, factored rising interest rates into their equation for its 2012 report regarding which risks pose the biggest threat to banks.

Many housing market pros feel that the rapidly dwindling number of refinancing loans is the most significant development in the world of mortgage banking. That’s due to the fact that in the last few months, refinancing activity has been the biggest show in town, since it made up the bulk of all home loans. But compared to last year, refi activity has dropped by 40 percent. This makes the MBA’s prediction for an annual drop of 20 percent look quite shaky.

Economists and financial insiders know that while low interest rates have limited profits for banks, the sheer volume of refinancing loans has more than made up for it. This really should not come as a big surprise to everyone else either, considering a January 17th headline in Fortune, which read, “The Refinance Boom Has Peaked.”

Stephen Gandel, a longtime Wall Street reporter and major contributor to Time and Fortune, reflects that it is truly difficult to pinpoint how much banks could lose in another economic downturn. The fact that interest rates are rising may not be all that dismal for banks after all. Gandel observes that, “Higher interest rates would allow the banks to charge more for loans. That could boost lending revenue and profits.” In case U.S. banks have any other possible solutions up their sleeves, we’ll just have to see what the stress test results reveal in September!

To give you an idea of what the Fed stress test does, here’s a look at the results of last year’s tests. In all, 19 banks were put to the test, but only 15 passed.


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