Most of the nation’s largest banks are in a much stronger capital position than they were before the financial crisis…

Most of the nation’s largest banks are in a much stronger capital position than they were before the financial crisis, according to results from the Federal Reserve’s third annual stress test released a week ago.  The test measures a bank’s ability to withstand a large shock to the economy and shows how much capital might be needed to absorb losses.  Eighteen banks participated in the test and all but one—Ally Financial—passed.  The 18 institutions collectively represent over 70% of the assets held by US banks.

While it’s not fail-safe, the stress test should provide some reassurance that most US banks are healthy enough to continue lending even if the country enters a deep recession.  Under the test scenario—which assumes a 50% drop in the stock market, a 20% decline in home prices, and 12.1% unemployment—losses at the 18 banks could total $462 billion over nine quarters.  That would push the banks’ Tier 1 common capital ratio, or the percentage of high-quality capital to risk-weighted assets, to 7.7%, down from 11.1% in September 2012.  This compares to roughly 5.6% at the end of 2008.  Bank of New York Mellon scored best with a 13.2% ratio, while government-owned Ally Financial (formerly GMAC) delivered the worst ratio—a meager 1.5%, which is far below the minimum required threshold of 5%.  In a press release, Ally, one of the country’s largest auto lenders, disputed the results and said the Fed’s loss rate assumptions for its automotive finance business are “implausible.”

The caveat to any financial stress test, of course, is that a severe shock to the system—like the credit crisis in 2007-2008—can unfold in ways that are greatly underestimated.  For instance, even if this stress test had been administered before the last crisis, it wouldn’t have captured the impact of something as severe or unthinkable as the collapse of a major counterparty institution such as Lehman Brothers. That’s why some investors remain wary of the results, especially considering the trillions of non-transparent derivatives exposure held by the nation’s largest banks.  (Derivatives are financial instruments that are valued based on the performance of a commodity, currency, interest rate, etc.)  The latest stress test estimated the 18 banks would suffer $97 billion in trading and counterparty credit losses in a deep recession scenario.  In our view, that seems tiny when compared to the $250 trillion in notional or face value of derivatives held by US banks as of September 2012, according to the US Treasury. That’s not to say the 18 banks aren’t healthier than they were prior to the crisis. Rather, we’re simply pointing out that many of the systemic risks five years ago are still relevant today.