The Federal Reserve Board on Thursday projected the potential for a rockier road ahead for banks than it did a year ago, but said the 33 financial institutions it reviewed passed its annual stress test of capital reserves.
The Fed estimated $612 billion in potential losses for banks in its most severe economic scenario, and said even if this comes to pass, banks would still be healthy enough to provide loans to homes and businesses to keep the economy afloat. That’s a $50 billion more-severe loss projection than a year ago by the largest banks.
“This year’s hypothetical scenario is tougher than the 2021 test, by design, and includes a severe global recession,” the Fed said in a statement.
The Fed’s model included a 5.75% increase in unemployment to 10%, a 40% decline in commercial real estate prices and a 55% drop in stock prices.
Under these conditions, the aggregate common equity capital ratio — a cushion against losses — would fall by 2.7% to a minimum of 9.7%, which is twice the minimum requirement. In 2021, the projected drop in aggregate common equity capital ratio was 2.4%.
After the test results, banks will be cleared to announce dividends and stock buybacks starting Monday, after the market closes.
Federal Reserve officials emphasized that the economic slowdown in the stress test is not a projection of how it expects the economy will actually perform, but rather a hypothetical to measure the strength of banks.
The stress test also assumed more than $450 billion in loan losses and $100 billion in trading and counterparty losses.
The banking system also has limited exposure to losses in crypto markets and is expected to remain resilient despite upheaval in that sector, Fed officials said.
The banking system started out the year with a 12.4% aggregate common equity capital ratio. It has dropped slightly in 2022 but remains well above historical levels, such as 5% in 2009 and about 10% in 2012, according to Fed data.
The stress tests cover the largest U.S. banks including JPMorgan Chase & Co. JPM, Goldman Sachs Group Inc. GS, American Express Co. AXP, Morgan Stanley MS, Wells Fargo & Co. WFC, Bank of America Corp. BAC and Citigroup Inc. C, as well as regional lenders.
Ahead of the results, bank stocks were mostly lower as Fed Chairman Jerome Powell testified for a second day before Congress and reiterated his commitment to fight inflation.
JPMorgan Chase declined by 1.1%, Goldman Sachs rose 0.6%, Citigroup fell 1.8% and Bank of America lost about 1.6%. The Financial Select Sector SPDR ETFS XLF retreated by 0.4%.
The stress tests measure balance sheets against capital requirements for banks as an indicator of their strength in a potential economic downturn. The results then shape how much capital banks will return to shareholders in the form of buybacks and dividends.
Ahead of the stress-test results, Cowen analyst Jaret Seiberg said Thursday he expected banks would pass, but he warned of potential pushback from lawmakers.
“The political risk today is that Capitol Hill questions why banks should distribute any capital if a recession is possible,” Seiberg said. “We do not see that winning the day, but it could get attention.”
Ian Katz of Capital Alpha said he expects some potential “snags” given the larger number of banks being stress-tested this year.
“This year’s tests are seen as being a bit tougher than last year’s,” Katz said in a research note. “For example, the global market shock element of the scenarios could cause challenges for banks with a lot of international exposure.”
The latest results reflect the Fed’s evaluation of 33 U.S. banks, up from 23 lenders last year. Banks with less than $250 billion in assets take the exam every two years instead of every year, under rules adopted in 2020. Large regional banks such as Fifth Third Bancorp FITB and Ally Financial Inc. ALLY are included this year after taking 2021 off.
The U.S. Federal Reserve reshapes the conditions of the tests each year, depending on key economic factors on the central bank’s radar screen.
Thursday’s stress test results mark the latest round of exams dating back to the Dodd-Frank bank reform legislation that followed the 2008 global financial crisis.
In 2021, The Fed said 23 of the largest banks operating in the U.S. would still hold more than twice as much capital as required even with $474 billion in losses in a potential recession. This conclusion led the Fed to scrap curbs on buybacks and dividends that it introduced as a reaction to the COVID-19 pandemic.