Cheat Sheet: What the Dodd-Frank Stress Tests Really Mean

WASHINGTON — Barely an hour after their release, industry representatives were already hailing the results of the Dodd-Frank stress tests as a sign of capital strength in banking.

Yet while the numbers do indicate higher capital positions and the industry's increased capacity to weather another crisis, attention is already shifting to what the Federal Reserve will say next week in a separate set of tests that could determine the level of upcoming dividend payments and other capital distributions.

To get a better handle on what the latest stress test results mean, and what comes next, we offer these responses to frequently-asked questions.

What happened?

The Federal Reserve Board disclosed the first wave of results from stress tests required under the Dodd-Frank Act.

Essentially, policymakers want to be able to gauge banks' ability to withstand another catastrophe in the financial markets. So the law required the Fed to subject large firms — those with over $50 billion in assets — to a simulation of how their portfolios would hold up under a number of stressed scenarios.

The Fed's release looked at how the 18 largest bank holding companies would fare in a "severely adverse" scenario. Senior officials at the central banks said the conditions assumed in the test were even worse than those of the 2008 crisis; imagine something more along the lines of the Great Depression.

The exact parameters of the test get a little complicated. The basic gist was this: The Fed started with where the companies' actual capital levels were in the third quarter of 2012, and — factoring in the structure of their portfolios and recent dividend payments — tested how their capital levels would respond to market stress over nine quarters ending in the fourth quarter of 2014. During that time, the firms would have to contend with conditions such as a peak unemployment rate of 12.1%, a more than 50% decline in equity prices and house prices falling more than 20%.

To be clear, this was only one set of results. Regulators have been carrying out stress tests since before Dodd-Frank. Results for a similar but different test carried out under the Fed's own authority are expected in just one week, and that next test may have a greater impact. (More on that later.)

OK, so what were the results?

By and large, the companies performed well, though with some variation. The average ratio of Tier 1 common capital to assets for the 18 firms never dipped below 7.4%. That means that if these were the results in an actual crisis, much of the industry would be safely above the "well-capitalized" threshold of 6% set by regulators.

Among individual firms tested, Bank of New York Mellon led the pack with a minimum Tier 1 common ratio of 13.2%, followed by State Street (12.8%) and American Express (11.1%). Only three firms fell below 6%: Goldman Sachs (5.7%), Morgan Stanley (5.8%) and Ally Financial, which had the poorest showing by far with a very low ratio of 1.5%. (For a full chart of the results, listed from highest capital to lowest, click here.)

Still, the ratios for both Goldman and Morgan Stanley were above the 5% buffer used in prior stress tests as the threshold for passing. And the Fed was quick to highlight the apparent improvement in firms' capital standing since the crisis, noting that their performance in aggregate eclipsed the 18 firms' actual Tier common ratio at the end of 2008 — when conditions were actually better than those imagined in the test — of 5.6%.

Yet Ally was seen as an obvious outlier. The Fed noted in its report that Ally's results were likely affected by the pending bankruptcy of its Residential Capital LLC subsidiary.

But in a press release shortly after the Fed's announcement, the company blamed the central bank's methodology.

"Ally Financial believes that the Federal Reserve's analysis of Ally's capital adequacy for the Dodd-Frank Act Stress Test … is fundamentally flawed and, while the Fed has not provided details, the analysis is inconsistent with historical experience in the most stressed periods in our business," the company said.

What does all this mean?

In the short term, the companies included in the first round of test subjects — with the likely exception of Ally — can enjoy positive headlines for having "passed" the Dodd-Frank stress tests. And regulators have an indicator to help them sleep a little better at night without worrying about the effects of the next shoe to drop.

Yet analysts will just finish digesting these results before they begin preparing for the next round of tests next week. Although some firms did better than others in the Dodd-Frank test, there was not really a passing grade per se. That changes on March 14, when the Fed will announce how the same firms performed in the central bank's Comprehensive Capital Analysis and Review.

The CCAR uses many of the same factors as in the Dodd-Frank test, but instead incorporates the companies' proposed future capital distributions, including dividend payments and stock repurchases. What that means is if a bank has a poor performance on its CCAR, the Fed could in essence reject its capital plan. (In a twist, a company can alter its proposed capital plan after seeing Thursday's results from the Dodd-Frank stress test.)

But the performance on the Dodd-Frank tests is not necessarily indicative of how banks will perform next week. In a note Thursday evening, Jaret Seiberg of Guggenheim Securities wrote: "We continue to believe it would be a mistake to read these results as saying the Fed next week will permit these banks to distribute more in dividends and buybacks than the modest increase over 2012 levels that we have been projecting."

What's next?

This is just the start of what might be known as stress test season.

Dodd-Frank also requires firms and their subsidiary banks to run their own internal stress tests based on standards set by their primary regulators. The first round of those company-run stress tests are due for institutions with over $50 billion in assets by the end of the March, but some firms already began announcing results from those tests on Thursday. Smaller companies will have later due dates. (Company-run tests are required of institutions with over $10 billion of assets.)

Additionally, the Dodd-Frank, company-run stress tests and the CCAR are annual exercises. Essentially, the stress tests have only just begun.