The Federal Reserve ordered the 19 largest U.S. banks to test their capital levels against a scenario of renewed recession with unemployment rising above 11 percent, said two people with knowledge of the review.

The banks stress-tested the performance of their loans, securities, earnings, and capital against at least three possible economic outcomes as part of a broader capital-planning exercise. The banks, including some seeking to increase dividends cut during the financial crisis, submitted their plans last month. The Fed will finish its review in March.

"They're essentially saying, 'Before you start returning capital to shareholders, let's make sure banks' capital bases are strong enough to withstand a double-dip scenario,' " said Jonathan Hatcher, a credit strategist specializing in banks at New York-based Jefferies Group Inc. Regulators don't want to see banks "come crawling back for help later," he said.

Executives at banks such as JPMorgan Chase & Co. in New York and PNC Financial Services Group Inc. in Pittsburgh have asked regulators for permission to increase dividends. The Fed has told banks that it expects dividends and share buybacks to be "conservative" and allow for "significant accretion of capital," according to a November notice. Some capital payout plans may be rejected as "inappropriate," the notice said.

The review "allows our supervisors to compare the progress made by each firm in developing a rigorous internal analysis of its capital needs, with its own idiosyncratic characteristics and risks, as well as to see how the firms would fare under a standardized adverse scenario developed by our economists," Fed Governor Daniel Tarullo said in an e-mail.

Eoin Treacy's view Banks began to talk about raising dividends as early as last November (also see Comment of the Day on November 9th) and have yet to receive approval for such measures from the Treasury. With the economy recovering and less leverage in the system generally, the potential for a double dip recession is diminishing. Monetary policy remains extraordinarily accommodative and while it is unlikely to get very much easier, the yield curve spread is a long way from an inverted position.

Prior to the financial crisis, the S&P 500 Bank Index yielded between 2 and 3% for much of the preceding decade. It currently yields 0.84% so it could double and still be within the confines of what might have been considered normal prior to 2007. A number of banks have been rallying at least in part because investors are beginning to price in the potential for an increased dividend but also because of a greater perception that the worst effects of the recession have been left behind.

I performed a Chart Library High/Low filter of financial shares in the S&P500 and 25 of the 46 are making at least new 3-month highs. None have made new lows in the last 5 days. 13 are making 2 and 3yr highs which is consistent with base formation completion. SLM Corp, Capital One Financial, Huntington Bancshares and SunTrust Banks are all breaking out of relatively lengthy ranges. American Capital Strategies remains in consistent medium-term uptrend and is currently testing the $10 area. A sustained move below the 200-day MA, currently near $6.70 would be required to question medium-term upside potential. Leucadia National Corp broke out of an 18-month range in December and continues to hit new recovery highs. While somewhat overextended in the short term, a sustained move below $28 would be required to question medium-term upside potential. T. Rowe Price bounced back emphatically from the September lows and continues to post new all time highs. It is currently overextended relative to the 200-day MA but a sustained move below $65 would be required to indicate that reaction towards that trend mean is getting underway.

We have often spoken of bank sectors as being integral to the progression of bull markets. This is because a bull market thrives on the provision of liquidity and banks should prosper in such an environment. They are also often leaders although it is unrealistic to have expected US financials to have led on this occasion since they were the epicentre of the credit crisis. However since financials are now performing at least in line with the wider market they offer an additional sign of the integrity of the medium-term bull market environment.

I reviewed a number of Japanese banks yesterday which are beginning to show signs of increased bullish interest. The FTSE-350 Banks has rallied bank to test the upper side of its 17-month range and clear downward dynamic would be required check potential for a successful upward break. The Dow Jones Euro Stoxx Banks Index has rallied to break the 16-month downtrend and is pressuring the succession of lower rally highs. A sustained move above 200 would greatly increase the chances that demand has returned to medium-term dominance.