According to the Federal Reserve’s annual stress tests, the largest US banks could lose $541bn under a hypothetical economic doomsday scenario. However, they would still have enough capital to absorb these losses.
The Fed’s Wednesday passing grades for banks such as JPMorgan Chase, Goldman Sachs and others have lent credence to Wall Street executives who claim that systemically important financial institutions are able to withstand large losses.
Results will also determine the amount of capital that banks must hold over the next twelve months. If banks meet or exceed the Fed’s requirements, there are no restrictions placed on them regarding how much capital can be used for shareholder dividends or stock buybacks.
Analysts predict that the capital requirements of Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Bank of America, will decrease due to these results. The results boosted hopes of higher dividends and more share buybacks. This sent the stocks of banks up by about 1.5 percent in after-hours trade. Results come only months after three of largest bank failures that have occurred in US history – Silicon Valley Bank (SVB), Signature Bank (SB) and First Republic – triggered a banking crisis. The stress tests did not include smaller banks, such as PacWest and Comerica that were under pressure by investors after the collapse of SVB.
Michael Barr, vice-chair of supervision at Fed, said in a press release that “today’s results confirm the banking system is resilient and strong.”
Barr, in a nod towards the recent crisis he warned that stress tests are “only one method to measure this strength” and regulators should “remain humble about the risks that can arise”.
Fed Stress Tests are annual exercises required by the Dodd-Frank Financial Regulations that were implemented after the 2008 crisis to gauge whether the banks’ loss-absorbing ratios would stay above the minimum requirements in an economic disaster.
The banks had to prove that they were able to survive a year of high unemployment, a drop in commercial real estate values by 40%, slashed house prices by 38%, and a fall in short-term rates to near zero.
UBS Americas and Deutsche Bank’s US subsidiaries suffered the largest capital losses of the 23 banks that were tested. Goldman’s capital levels fell the most among the banks headquartered in the US, followed by Morgan Stanley. Both banks’ businesses skew more than peers towards trading, which is classified as riskier by the Fed.
Tests showed that despite projected losses of $424bn, all banks, including Bank of America and Citigroup, State Street, Wells Fargo and State Street, would still meet the minimum capital requirements. The losses were $424bn in loan losses, and $94bn in trading and counterparty losses.
Eight of the largest banks would experience trading losses worth nearly $80bn in a scenario where inflation is high and requires steep interest rates. This environment is similar to today’s economic outlook.
The results of the stress tests will be used to determine what is known as a “stress-test capital buffer” for each bank. The amount of common equity Tier 1 capital that they must have in excess of the regulatory minimums relative their risk-weighted asset is what this is.
The stress capital buffer is the sum of the maximum loss of CET1 during the stress test, and the capital return plans of the bank for the next twelve months through dividends.
Starting Friday, the banks that were tested will be able confirm publicly their stress-capital indication. They may also announce potential buyback plans or dividends.
The Fed and other US bank regulators are expected to publish new international standards in the summer of this year for calculating risk weighted assets. These rules, also known as Basel III Endgame Rules, will be published by the Fed.
Analysts and bank executives expect that these rules will require American banks to hold more CET1 (Capital Effectiveness Test) capital. These rules will bring the US into line with international standards.
The Financial Services Forum (a Washington-based lobby group representing the largest US banks) said that the results showed that lenders have sufficient capital, and stricter requirements are not necessary.
The FSF released a statement that stated, “The post-Dodd-Frank reforms have met the goal of a safer and stronger banking system.”
US regulators will also likely expand the Basel rules so that they include midsized banks similar to Silicon Valley Bank Signature Bank and First Republic.
After SVB’s collapse, the list of banks that will be subject to Fed stress tests is being closely scrutinized due to their exposure to excessive interest rate risks arising from their stock of unhedged bonds.
According to the current rules that were implemented in 2019 after legislation was passed that relaxed regulations for midsized lenders (SVB), SVB’s stress test first would have been conducted only in 2024.
The scenario that was used to model the sharply increased interest rates which led to SVB’s demise did not include the type of rate increases that caused the lender’s collapse.