Banks stress test: implication for spread betting

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Results of banks stress test conducted by the US government have dominated the financial news for the past couple of weeks. However, while a lot has been written on the subject, few have examined the specific implications for financial spread betting.

Here, we discuss briefly the background to the bank tests, outlining why they were needed in the first place. We then take you through the published results and implications for some of America’s biggest banks. We assess the financial market response to the publication of the stress-test results and examine the potential spread betting opportunities that could arise as a result.

Background to the banks stress test

Several months ago, investors and depositors deserted the banking sector, leading to sharp declines in the share prices of banks listed on major equity indices including the FTSE 100 and the S&P 500 indices. A crucial reason for the dramatic sell off in share prices was the heightened uncertainty as to whether the financial institutions were solvent.

Bans on short selling by a number of financial regulators such as the FSA in the UK and the SEC in the US provided some short term respite for banks. However, it was clear that a more lasting solution required that the banks were somehow able to demonstrate to nervous investors and depositors that they were sufficiently funded to withstand the shock to their balance sheets. It is this nagging uncertainty that banks stress tests were designed to address.

So, in an attempt to reduce speculation about the possibility that one or more of the major banks in the United States could still go bankrupt due to the ongoing economic downturn, the US government and Treasury decided to subject the major banks to a series of tests.

The stress tests were conducted over a period of about two and a half months, and involved the nineteen largest financial institutions in the US. The tests were designed to simulate the potential impact of further deterioration in the US economy in particular and the global economy in general on the banks’ balance sheets.

Bank stress tests: the main results

The results essentially split the US banking sector into two groups: the stronger group—those that the Treasury felt were in a sound financial position, with adequate capital to withstand further shocks to the financial system; and a weaker group of banks that needed to bolster their capital levels. In all, the Federal Reserve—the US Central Bank—directed at least seven of the country's largest banks to enhance their capital levels to the tune of about $65 billion.

The major financial institutions seemingly in the clear are listed below:

J.P. Morgan Chase,
Goldman Sachs Group,
MetLife Inc,
American Express Co.,
Bank of New York Mellon and
Capital One Financial Corp.

These financial institutions are not expected to be required to raise additional capital by the US financial regulators.

However, a number of major banks have extensive capital requirements. The more significant ones are listed below:

Bank of America,
Wells Fargo & Co,
Morgan Stanley,
State Street Corp,
Regions Financial

The amount of the capital shortfall range from about $1.5 billion to roughly $34 billion. Bank of America needed the most additional capital.

Focus on market expectations

As every spread better ought to know, and as we have explained elsewhere on the spread bet trader web site, whatever the fundamental or economic news may be, it is not so much the news that moves the market but the deviation of such news from prevailing market expectations.

A clear example of this occurred when the results of the stress tests were finally released. The financial markets simply shrugged them off and the Dow Jones Industrial Average, FTSE 100 index and Standard and Poor’s 500 index all rallied strongly. This was largely because the market had expected the results of the tests to be worse than they actually turned out to be.

Spread betting implications of banks stress test

While the initial market reaction to the results of the banks stress tests have been benign, this should not be taken as a guarantee that the banking sector is out of the woods completely.

In the short term, the question remains as to whether the more stable banks outlined above can stand on their own feet without further recourse to bailout money; and perhaps more importantly, whether the weaker banks identified can raise the required capital and recover without extensive government handout. Any signs that suggest otherwise should present opportunities for spread bet traders betting on price declines.

Longer term, it remains unclear whether the banks stress tests were indeed tough enough in the assessment of the potential worse-case economic scenario. Some analysts already argue that the Federal Reserve’s worse-case scenario was particularly rosy.

That is because in conducting the stress tests on the banking sector, the US government defined the worst-case scenario as two-year cumulative losses of about 9.1 per cent on total loans. Remember that the stress tests were designed to measure the potential losses on commercial loans, mortgages, securities and other assets held by the major banks being examined.

Should the economy worsen beyond the assumptions used in the banks stress tests, there will undoubtedly be substantial spread betting opportunities for short term traders. Specifically, spread bet traders should prepare for further short selling opportunities in the banking sector in particular but also in the wider financial sector in such a scenario.

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