Bank stress test refers to an analysis conducted in times of a weak economic period designed to determine if a bank has sufficient capital to weather the impact of detrimental developments. In the United States, the Federal Treasury reviews unfavorable economic situations and evaluates if a bank can withstand it. The economic inputs used in the test includes real GDP, unemployment, and housing price appreciation.

First, bank regulators will look for toxic assets, which may be illiquid and inflated in value. Normally, such assets refer to the bank’s investment securities and loans. Since majority of the banks’ toxic assets are loans, regulators will segregate the loans according to loan type and appraise losses according to the above-mentioned economic inputs since these are said to be connected to the current credit cycle. They will also look at delinquency rates in several categories and add it to loss severity to find out loss rates. Then, the rates are applied to the loans to project equity depletion over the loss period, which is usually two years.

Next, the government will look for potential credit impairment in bank-held securities, including collateralized debt obligations and uninsured mortgage-backed securities. It will discount the securities’ market value and come up with a cumulative loss rate. And, the regulators will account the bank’s counterparty risk and discount bank with too much concentrated exposure.

Upon accumulating and adding up the potential loss and potential income gains, regulators offset the two and tax them at current tax rates, since it will be included in the income statement. A net loss will be the outcome since banks are stressed adversely. The loss will then be applied against the present capital balances called pro forma (as if) capital.

Lastly, regulators will get into key banking measures such as common equity levels and total capital levels. If a bank surpasses the levels set by regulators as well capitalized, the bank in question passes the test. Conversely, the bank will need to generate more capital. Should the bank fail to raise additional capital, the Federal Deposit Insurance Corporation (FDIC) has an option to close the bank. Therefore, the bank’s clients who have deposits over federally insured threshold will receive a portion of their money at risk, which might lead to a bank run. Also, the investors’ assets will be wiped out because all the remaining bank equity will be liquidated in order to pay depositors and debtors first.

Do not panic if you learn your bank will undergo a stress test, but try to rationalize whether your bank can make it or not. You may consider doing the following: Try to study reports and conduct the mathematical exercise. But not everyone has the heart to do it. So you may also check the kinds of loans your bank makes. High exposure in poorly secured loans might be a problem.

Another is to examine financial ratios. The Texas ratio is frequently referred to as an indicator to bank failure. It is based off of nonperforming and delinquent loan, compared with equity and loan reserve levels. If the ratio is higher, that is the time you should become worried. Also, take into account the capital adequacy ratio, expressing the bank’s risk-weighted credit exposure by gauging its Tier 1 and Tier 2 against its risk-weighted assets.

How does a bank perform compared to its rivals? If the ratios are way higher than the bank median, it is a good sign. But if it is lower, that is a warning sign. In times of economic boom, financial institutions may retain their capital levels low to return more money to shareholders through capital.

But in down markets, it can come back to impact the banks since their capital will notice magnified erosion. Most banks rarely fail, but those who have lower capital levels and poor underwriting will be affected first. With all else being equal, being in a bank that is more in the center of the pack on ratios than at the low end is a safer investment and financial institution.

Reading research reports is the last thing investors and depositors can do. Normally written by savvy bank analysts who are well familiar with the business, they will state if a given bank is weak and likely to endure duress under a stress test. But if their reports lead to negative, the client or investor may find elsewhere for safer banks.