As the sovereign debt crisis in Europe threatens to spill over into the United States, the federal government wants to make sure that banks are prepared to weather the storm.
The Federal Reserve announced on Tuesday that it would require 19 large financial institutions to undergo stress tests to ensure that they have enough capital to continue to operate during "stressed macroeconomic and financial market scenarios." The Fed also is requiring the six largest financial firms -- including Goldman Sachs, Bank of America, and Citigroup -- to estimate the losses that would result from "a hypothetical global market shock," based on market price movements during the second half of 2008 with adjustments reflecting that the crisis would originate this time from European sovereign bonds and banks.
"Institutions will be expected to have credible plans that show they have sufficient capital so that they can continue to lend to households and businesses, even under adverse conditions," the Federal Reserve said in a statement.
The move sent a clear signal that the Fed is not taking any chances with brewing troubles in Europe. If the European Central Bank can't contain the crisis, then the continent would likely dive into recession and freeze credit in Europe and possibly the United States. The scenario would place severe financial stress on American banks and raises the potential for a retread of the 2008 post-Lehman atmosphere.
The Federal Reserve would ban large banks in shaky condition from increasing their dividends for shareholders, approving dividend increases and stock buybacks only for banks that are able to "demonstrate sufficient financial strength" under stressed conditions, according to the Federal Reserve statement.
The six largest financial firms will need to model their response to a deep recession in the euro zone, where the economy shrinks 6.9 percent, and a U.S. unemployment rate of 13 percent, according to The Financial Times.
This is the third round of stress tests conducted by the federal government. The first stress test in the spring of 2009 was meant to boost the country's confidence in its banks, and the second stress test, finished in March, allowed some banks to increase dividends for shareholders, according to The Wall Street Journal. Ominously, some weaker banks did not pass the second stress test to be able to raise dividends, including Bank of America, according to the WSJ.
The Fed is requiring the country's 19 largest financial institutions to submit their stress test reports by January 9, leading The Financial Times to compare the Federal Reserve to the financial industry's Grinch who stole Christmas.
"There's a ban on vacation time for the staff involved," one bank executive said to The Financial Times.