In compliance with Dodd-Frank, the Federal Reserve will soon subjecting banks to its Comprehensive Capital Analysis and Review (CCAR) program, which amounts to stress tests.

The goal is to find out just how well positioned banks are against economic weakness and market shocks and determine where they stand in regard to Basel III capital requirements. The Fed recently announced that banks have until January 9, 2012, to submit their capital plans for review.  The top six banks will be given additional testing this year and will be required to estimate their potential losses from a global market shock, one akin to the dislocations experienced in the second half of 2008.

So how will banks fare? Most observers are taking an optimistic tone. Goldman Sachs analysts, for example, "conducted their own stress tests using the Fed's worst-case scenario--13% unemployment, a 21% decline in home prices and a 52% peak-to trough decline in the stock market--and they say that the banks came out looking squeaky clean," according to Barron's, which quotes from the report.

The report continued, noting that, "despite simulating a more difficult stressed scenario than the prior year...we believe most banks are well positioned for the 2012 Fed stress test. Reduced leverage, higher quality assets (lower risk, limited/no prop trading) and higher capital levels relative to prior exams should help banks withstand the stress of the Fed's exam...Given the high capital levels in the industry, we believe there is nearly $900 billion of loss absorption capacity. As such, all of our banks passed our test."

The ubiquitous Richard Bove also suggests that the top banks will pass with flying colors. Others are not so sure. Analyst Mike Mayo has said that three banks--Morgan Stanley, Bank of America and Citigroup--may have some issues. He cites "inconsistent strategies, unstable management and bad risk management."

These stress tests can be unpredictable. Many thought Bank of America would be given a clean bill of health to hike dividends last year, until the Fed put an end to that idea after a stress test. The Fed is already after Bank of America to improve risk management and compliance practices.   

For more:
- here's the Barron's article

Related article:
Fourth round of stress tests coming