Fed stress test shows the biggest US banks are strong enough to withstand severe recession
The Federal Reserve’s annual stress tests released Wednesday show that the largest US banks could withstand a severe recession with plenty of capital on hand to absorb hundreds of billions in losses.
This year, the Fed’s regulatory exam applied to 32 banks with assets of more than $100 billion, a group that included Wall Street giants such as JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), Goldman Sachs (GS), and Morgan Stanley (MS).
All 32 lenders were able to show that their capital levels would stay above a key threshold in a hypothetical severe global recession triggered by an abrupt decline in risk appetite that causes the prices of risky assets to plummet. Under the scenario, real GDP contracts by 4.6%, unemployment soars to 10%, home prices plunge 30%, commercial real estate prices plunge 39%, and the stock market drops by nearly 58%.
The ratio of their common equity tier 1 capital — high-quality capital that would serve as a primary safety net — for all banks as a group fell from 12.8% to a projected minimum 11.2% before rising to 12.7%, well above the required minimum of 4.5%. That compares with capital falling to 11.6% for the group of 22 banks that participated in a different set of tests last year.
The banks’ losses in this year’s simulation collectively amounted to more than $708 billion. That included $203 billion from credit card losses, $158 billion from business loans, and $77billion from commercial real estate.
In this year’s hypothetical test, interest rates declined less while banks’ net interest income from lending activities also helped offset the drawdown in commercial real estate prices. On the other hand, equity prices also declined more than the prior year, leading to larger losses on loans to businesses.
“Today’s results underscore the strength of the banking system,” the Fed’s Vice Chair for Supervision Michelle Bowman said. “As we work to increase the transparency and accountability of the stress test, public feedback will help us continue to improve and instill greater confidence in the stress test and its results.”
The Fed’s stress tests were mandated annually by law after the 2008 financial crisis for banks with $100 billion or more in total assets. They assess whether banks could continue lending to households and businesses during a hypothetical severe recession in order to prevent bank failures in a future crisis.
The stress tests estimate bank losses, revenues, expenses, and resulting capital levels — which provide a cushion against losses — under hypothetical recession scenarios. The Fed uses the results of a stress test, in part, to set large bank capital requirements.
For years, banks have waited for the results before setting their annual capital framework, which includes deciding whether to increase or lower dividend payments and buy back shares.
But a passing grade this year isn’t expected to fully solidify many banks’ capital plans, according to Chris McGratty, an equity analyst for KBW.
Last October, the Fed proposed publishing the models and methodologies it uses each year to stress-test the nation’s largest banks, in an effort to increase transparency into the tests. In February, the board also voted to maintain the current stress capital buffer requirements until 2027, when new requirements can be calculated based on models that take public feedback into consideration.
Another change this year is that the Fed is re-using virtually the same test models as last year, but with a different stress scenario. Until now, the stress test models were not disclosed to banks. That also means banks don’t need to wait because the results aren’t expected to impact their capital plans as the Fed solicits feedback on the models it uses for stress tests.
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Bowman says that waiting to make changes until public feedback is received gives the central bank the ability to correct deficiencies in its models while also improving transparency and effectiveness.
“It’s a bit of a punt to next year, and I think there’s a couple banks that are probably frustrated by that process,” McGratty said Tuesday, pointing out that KBW projects Citigroup and Morgan Stanley as well as regional lenders Citizens Financial Group (CFG) and KeyCorp (KEY) would have benefited the most had results counted toward their capital requirements.
However, some big banks did share capital plans immediately after the test results.
JPMorgan Chase is raising its quarterly dividend payment by $0.15 to $1.65 beginning July 1 and authorizing a new $50 billion share buyback program, according to press release.
“The current environment reflects an increasingly complex set of risks,” JPMorgan CEO Jamie Dimon said in a statement. “We are prepared for a wide range of scenarios,” he added.
Starting next month Goldman Sachs is boosting its dividend too, raising the quarterly payout by $0.50 to $5.00. “Our planned dividend increase reflects the strength of our franchise,” CEO David Solomon said in a statement.
Morgan Stanley, Citigroup and Wells Fargo also each raised their dividends by $0.15, $0.07 and $0.05. Morgan Stanley also authorized a $20 billion share buyback program.
Bank of America said it will make its next quarterly dividend announcement following its July board meeting, according to an emailed statement.
Banks are also awaiting Basel III Endgame, a larger capital proposal the Fed is expected to unveil later this year. Earlier this month, banks formally asked the Fed for changes to those proposed rules, including reducing the levels of capital assigned to certain Wall Street trading activities and unused credit card lines. Basel III is a set of rules held over from after the financial crisis designed to put banks on a level playing field globally. Other countries, including the EU, have largely already put those rules in place.
Still, the annual test marks the latest signal to the Fed and the public that a crucial piece of the US financial system would remain resilient in an economic downturn.
David Hollerith is a senior reporter at Yahoo Finance covering the cryptocurrency and stock markets. Follow him on X at @DsHollers.
Jennifer Schonberger is a veteran financial journalist covering markets, the economy, and investing. At Yahoo Finance she covers the Federal Reserve, Congress, the White House, the Treasury, the SEC, the economy, cryptocurrencies, and the intersection of Washington policy with finance. Follow her on X @Jenniferisms and on Instagram.
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