Will The Fed’s Stress Tests Challenge Large-Cap Banks?

The Federal Reserve will announce the results of its annual stress tests, known as the Comprehensive Analysis and Review, on Thursday, and along with the central bank’s findings, investors are expecting a tidy little bonus. If the Federal Reserve determines that the United States’ largest banks can withstand a significant deterioration in economic conditions, bank stocks will be hit with a much-needed catalyst: permission to raise dividends or repurchase shares.

To pass the Fed’s assessment, each of the 19 banks in question — from Citigroup (NYSE:C) to Bank of America (NYSE:BAC) — will have to show they can absorb significant financial losses under “adverse scenarios,” payout dividends or buy back shares, and still maintain Tier 1 common equity ratios of at least 5 percent. Regulators view Tier 1 capital as the core measure of a bank’s financial strength as it is the ratio of an institution’s equity capital to its total risk-weighted assets.

After the financial crisis, politicians and regulators searched for a means to repair the structural problems within the international banking system in order to insure that similar financial meltdown would never happen again. The Basel Committee on Banking Supervision — consisting of representatives from central banks and regulatory authorities from the world’s 20 largest economies — determined a global regulatory standard for bank capital adequacy, stress testing, and market liquidity risk.

Out of this standard, the Federal Reserve developed its own banking stress tests, which will primarily test how well prepared banks are to handle another crisis or adverse scenarios…