Fed says banks can withstand 10% unemployment, 55% stock price drop in annual stress test

The Federal Reserve Board on Thursday forecast the potential for a more difficult path for banks than a year ago, but said the 33 financial institutions it assessed passed its annual capital reserves stress test.

The Fed estimated $612 billion in potential losses to banks in the most severe economic scenario, saying that even if this happened, the banks would still be healthy enough to lend to homes and businesses to keep the economy afloat. That’s a forecast of $50 billion more serious losses than a year ago by the largest banks.

“This year’s hypothetical scenario is more difficult in design than the 2021 test and includes a severe global recession,” the Fed said in a statement.

The Fed’s model included a 5.75% to 10% rise in unemployment, a 40% drop in commercial real estate prices and a 55% drop in stock prices.

Under these circumstances, the total common equity ratio – a buffer against losses – would fall by 2.7% to a minimum of 9.7%, which is twice the minimum requirement. In 2021, the expected decline in the total common equity ratio was 2.4%.

Following the test results, banks will be allowed to announce dividends and share buybacks from Monday, after the market closes.

Federal Reserve officials stressed that the economic slowdown in the stress test is not a projection of how it expects the economy to actually perform, but rather a hypothetical one to gauge the strength of banks.

The stress test also assumed more than $450 billion in credit losses and $100 billion in trade and counterparty losses.

The banking system also has limited exposure to losses in crypto markets and is expected to remain resilient despite the turmoil in that sector, Fed officials said.

The banking system started the year with a total common equity ratio of 12.4%. It has fallen slightly in 2022, but remains well above historical levels, according to Fed data, such as 5% in 2009 and about 10% in 2012.

The stress tests concern the largest US banks, including JPMorgan Chase & Co. JPM,
-1.09%
Goldman Sachs Group Inc. GS,
+0.57%
american express co. AXP,
-1.90%
Morgan Stanley MS,
-0.58%
Wells Fargo & Co. WFC,
-1.81%
Bank of America Corp. BAC,
-1.60%
and Citigroup Inc. c,
-1.80%
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 determination to fight inflation.

JPMorgan Chase fell 1.1%, Goldman Sachs rose 0.6%, Citigroup fell 1.8% and Bank of America lost about 1.6%. The financial sector selected SPDR ETFS XLF,
-0.38%
decreased by 0.4%.

The stress tests measure balance sheets against banks’ capital requirements as an indicator of their strength in a potential economic downturn. The results then determine how much capital banks will return to shareholders in the form of buybacks and dividends.

Ahead of the results of the stress test, Cowen analyst Jaret Seiberg said on Thursday he expected the banks to succeed, but warned of possible pushback from lawmakers.

“The political risk today is that Capitol Hill wonders why banks should allocate capital if a recession is possible,” Seiberg said. “We don’t see that winning the day, but it could get attention.”

Capital Alpha’s Ian Katz said he expects some potential “problems” given the increased number of banks under stress this year.

“This year’s tests are seen as a little more difficult than last year’s,” Katz said in a research note. “For example, the global market shock element of the scenarios could create challenges for banks with a lot of international exposure.”

The latest results reflect the Fed’s assessment of 33 US banks, compared to 23 lenders last year. Banks with less than $250 billion in assets take the exam every two years instead of every year, according to rules passed in 2020. Major regional banks such as Fifth Third Bancorp FITB,
-2.76%
and Ally Financial Inc. ALLY,
+1.15%
were included this year after taking 2021.

The US Federal Reserve reshapes the terms of the tests every year, depending on key economic factors on the central bank’s radar screen.

To see: Powell says US economy can handle upcoming rate hikes

Thursday’s stress test results mark the latest round of exams dating back to the Dodd-Frank banking reform legislation that followed the 2008 global financial crisis.

In 2021, the Fed said 23 of the largest banks operating in the US still hold more than twice as much capital as they need to, even with $474 billion in losses in a potential recession. This conclusion prompted the Fed to lift the restrictions on buybacks and dividends it introduced in response to the COVID-19 pandemic.

Also read: US banks pay $2 billion extra in quarterly dividends after Fed green light

Leave a Comment