The Federal Reserve on Wednesday announced the 23 largest US lenders had passed the Central Banks Stress Tests. The banks showed they can withstand a severe global recession and turmoil in real estate markets. The Fed released the hypothetical scenarios for its annual bank stress tests back in March before the New York and California regional bank turmoil. The 23 banks were tested against a severe global recession with heightened stress in both commercial and residential real estate markets, as well as in corporate debt markets.
The Fed is also weighing an overhaul of its supervision efforts given the Regional Bank maelstrom. The central bank said the banks can start announcing their payout plans on Friday. Last year the Fed found all 34 large banks tested remained well above their risk-based minimum capital requirements, and the Fed announced no restrictions relating to dividends and buybacks.
These test results were keenly watched with the worrying state of the economy through an energy crisis and soaring inflation, which have since subsided, low consumer sentiment remains. The world is also on a war footing since Russia’s invasion of Ukraine and the US’s uneasiness with China.
The stress tests help ensure that large banks can support the economy during economic downturns, estimating their losses, revenue, and capital levels under hypothetical scenarios. Banks are bound by their stress capital buffer (SCB) framework in terms of returning cash to shareholders. However, if they have excess capital, dividend and buyback increases are now allowed.
Banks Could Lose $541 billion Tests Concluded
The Fed hypotheticals concluded the banks would cause banks to lose $541 billion, including $100 billion in losses from commercial real estate and residential mortgages. The losses are in line with those estimated in previous years.
In the scenario that assumed a 40% slump in commercial real estate prices, banks saw losses on loans tied to the sector hit $64.9 billion. The Fed said its supervisors have increased their efforts to understand banks’ credit risk exposure to the industry, which has been souring in a new era of remote work that’s lowered office occupancy levels nationwide.
“The test’s focus on commercial real estate shows that while large banks would experience heavy losses in the hypothetical scenario, they would still be able to continue lending,” the Fed said in a statement. “The large projected decline in commercial real estate prices, combined with the substantial increase in office vacancies, contributes to projected loss rates on office properties that are roughly triple the levels reached during the 2008 financial crisis.”
Chairman Jerome Powell indicated earlier this month that the biggest banks could face a 20% increase in the amount of capital that they’re asked to set aside that under the new Basel III requirements. He added that the eight biggest US firms will likely bear the bulk of this.
The Federal Reserve Hypotheticals for the tests:
The Board’s stress test evaluates the resilience of large banks by estimating losses, net revenue, and capital levels—which provide a cushion against losses—under hypothetical recession scenarios that extend two years into the future. The scenarios are not forecasts and should not be interpreted as predictions of future economic conditions.
In the 2023 stress test scenario, the U.S. unemployment rate rises nearly 6-1/2 percentage points, to a peak of 10 percent. The increase in the unemployment rate is accompanied by severe market volatility, a significant widening of corporate bond spreads, and a collapse in asset prices.
In addition to the hypothetical scenario, banks with large trading operations will be tested against a global market shock component that primarily stresses their trading positions. The global market shock component is a set of hypothetical shocks to a large set of risk factors reflecting market distress and heightened uncertainty.
For the first time, this year’s stress test will feature an additional exploratory market shock to the trading books of the largest and most complex banks, with firm-specific results released. This exploratory market shock will not contribute to the capital requirements set by this year’s stress test and will be used to expand the Board’s understanding of the largest banks’ resilience by considering more than a single hypothetical stress event. The Board also will use the results of the exploratory market shock to assess the potential of multiple scenarios to capture a wider array of risks in future stress test exercises.
The table below shows the components of the test that apply to each bank, based on data as of the third quarter of 2022. Table 1 in the scenario document has additional information.
2022 Fed Stress Test Results
- The 2022 stress test shows that large banks have sufficient capital to absorb more than $600 billion in losses and continue lending to households and businesses under stressful conditions.
- In large part, this is due to the substantial buildup of capital since the 2007–09 financial crisis
- All banks remain above minimum capital requirements in a hypothetical downturn despite the larger post-stress decline this year, the aggregate and individual bank post-stress CET1 capital ratios remain well above the required minimum levels throughout the projection horizon
- 34 large US banks have strong capital levels, and could continue lending in an economic downturn
- Under the severely adverse scenario, the aggregate common equity tier 1 (CET1) capital ratio falls from an actual 12.4 percent in the fourth quarter of 2021 to its minimum of 9.7 percent, before rising to 10.3 percent at the end of the projection horizon.
- The 2.7 percentage point aggregate decline this year is slightly larger than the aggregate decline of 2.4 percentage points last year.
For shareholders, the extra cash that this implies is welcome news. But it is also reassuring to the market generally to hear confirmation that banks have sufficient capital. The housing crisis in 2008 exposed some systemic liquidity risks at the banks. It’s good that the Fed is now playing closer attention to capital levels. With recession talk from President Biden to Fed Chair Powell concern will be 2022 underperformance, damaged economic recovery, and decreased credit spending by consumers.
How The Banks Reacted after Coming Out of The Pandemic
A point of order for those trading the banking sector on these results the banks do not react entirely uniform on them. When the banks were first allowed to do buy backs and dividend Morgan Stanley’s (MS) response was probably the most notable, as it doubled its quarterly dividend to $0.70/share. MS also upped its share buyback authorization to $12 bln. Goldman Sachs (GS) upped its quarterly dividend to $2.00/share from $1.25/share. Others that announced dividend increases include BAC, BK, USB, PNC, TFC, and JPM.
A notable exception was Citigroup (C), which said that it expects dividends of at least $0.51/share (its current level) and that it plans to continue share repurchases. In fairness, unlike many others, Citi maintained its $0.51/share during the pandemic. It has been at that level since August 2019, so it’s understandable that the company did not raise it. Others not raising include COF and RF.
Source: Federal Reserve
From The Traders Community News Desk