By: Kalyan Nandy - Zacks Equity Research

America’s largest banks will have to endure another round of stress tests in upcoming weeks to prove their financial strength to confront another recession, Federal Reserve Vice Chair Janet Yellen said Friday at a banking conference.

This will mark the fourth round of bank stress tests since 2009. The tests monitor the 19 banks regulated by the Federal Reserve.

The selected banks, including Citigroup (C), Bank of America (BAC), JPMorgan Chase (JPM)and Wells Fargo (WFC), will need to demonstrate that they have adequate capital to address potential losses over the next two years under several stressful scenarios.

Yellen has also expressed concerns over the European debt crisis. However, she said that the situation will be closely monitored to tackle any negative impact that the crisis might have on the U.S. financial system.

The environment of the last two rounds of stress tests and the upcoming one are dissimilar to the Fed's first round. The first round, conducted when the country was teetering under tremendous recessionary pressure, was aimed at estimating how much the banks would lose if the economic downturn proved deeper than expected. Since then, the test rounds are more like precautionary measures amid economic recovery.

The history

Though capital strength verification is definitely a necessary step in the midst of the economic recovery, this decision was not taken by the Federal Reserve independently. When the recession struck, the Fed had barred all banks from increasing dividends.

Following sharp cuts in dividends due to increased government intervention, banks had been pressuring regulators for months to let them restore dividends after they had repaid the bailout money. The primary intention of banks was to attract new investors by enhancing dividend payments. Since 2010, the Fed has been keeping this demand of those banks that pass its stress tests.

The requirements

The banks need to file capital plans well in advance to undergo the new tests. They will have to adhere to this requirement even without any plan to increase dividend payments. The banks that intend to boost dividends will also have to prove their capability to comply with the upcoming tougher Basel III banking regulations.

If a bank fails the test, it will have to take initiatives to raise new capital to meet the Fed requirements.

Way to recovery

The economic benefits of the stress tests are indisputable. These would somewhat reconstruct the banks’ weak capital level, which threatens the economy. Also, this could ultimately translate into less involvement of taxpayers’ money for bailing out troubled financial institutions.

While the government has been closely monitoring bigger banks and has also extended help through various stimulative programs, many smaller banks are still struggling to stay afloat. Tumbling home prices, soaring loan defaults and a high unemployment rate continue to take their toll on small institutions. The government should set policies to help all the industry participants contribute to the overall profitability.

However, if most of the major banks pass the stress test, this will definitely accelerate the pace of economic recovery.

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