New Stress Tests Expected to Show Progress at Most Banks In another milestone in the banking industry's recovery from the financial crisis, the Federal Reserve this week will release the results of its latest stress tests, which are expected to show broadly improved balance sheets at most institutions. Tannen Maury/European Pressphoto Agency Bank of America, though still coping with the effects of billions in soured subprime mortgages, is expected to pass its stress test. Chris Goodney/Bloomberg News Wells Fargo is expected to earn high marks. The findings would be the latest of several signs of renewed strength in the economy, including the unemployment report last Friday that showed that more than 227,000 jobs were created in February. For the financial sector, including traditional banks and Wall Street firms that were at the heart of the panic during the crisis, the recovery has been slow but steady, with some banks recovering much faster than others. Still, while unpleasant surprises are possible, analysts are counting on the Fed to find banks largely healthy. That would stand in marked contrast with the holes, in the tens of billions of dollars, found on balance sheets in the first round of stress tests in 2009. "Everybody wants to avoid headlines," said Chris Kotowski, an analyst with Oppenheimer. People are angry at the banks, and both the banks and the regulators just want to do something to show we're working our way back towards normalcy. That's what everyone is craving. The examination is not merely an intellectual exercise. If institutions fall short, they could be required to raise billions in new capital, depressing their shares. If they pass, dividend increases and stock buybacks by the strongest institutions will follow as they did after the second round of tests a year ago, pleasing investors whose banks" stocks still trade at levels far below where they where before the collapse of Lehman Brothers in September 2008. Under the tests, Federal Reserve specialists are trying to predict how capital levels at the 19 largest banks would withstand an economic downturn even more severe than the one that followed the Lehman collapse. In addition to a 50 percent stock market decline and an 8 percent contraction in real gross domestic product, the tests envision an unemployment rate of 13 percent, well above the 10.2 percent peak recorded in October 2009. A surge in unemployment would increase losses for banks on mortgage and credit card debt. If all that were not enough, the Federal Reserve is considering what would happen to bank assets if a market shock hit Europe and reverberated in the United States, gauging the extent of losses that have not loomed large for American institutions, despite the continuing problems in Greece and weaker European borrowers. Regulators are walking a fine line: if they permit the banks to return too much capital now, that might leave the industry vulnerable in the event of a downturn and lead others to think the industry was returning to its risky ways. On the other hand, a raft of negative results would alarm investors just as calm seems to be returning to the markets. "It's going to end up being a compromise between regulatory constraints and what the banks desire," said Kamal Mustafa, chairman and chief executive of Invictus, a consulting firm in New York that focuses on the financial sector. For banks to pass the tests, they must show that their Tier 1 capital ratio - the strictest measure of a bank's ability to absorb financial blows - will be at 5 percent or better, even in the Fed's nightmare case. To raise dividends or buy back stock, the ratio would have to remain above 5 percent, after capital was returned to shareholders. Tier 1 capital ratios for the 19 largest banks have improved since the depths of the financial crisis, rising to 10.1 percent in the third quarter of 2011 from 5.4 percent in the first quarter of 2009. Actual capital in dollar terms has jumped to $741 billion from $420 billion. "The industry is on much firmer ground than it was three years ago," said Jason Goldberg, an analyst for Barclays. This will show how much progress the banks have made in cleaning up their balance sheets.