Both Morgan Stanley (MS 1.47%) and Goldman Sachs (GS 1.08%) will see their regulatory capital requirements reduced slightly after the Federal Reserve identified an error in its stress test calculations.
The Fed said in a statement that an error was made while projecting trading losses, not properly calculating losses for "certain public welfare investments" made by some of the largest banks.
The Fed said five banks were impacted by the error, including Citigroup (C 1.52%), Wells Fargo (WFC 2.08%), and HSBC (HSBC 0.63%). But the error only resulted in capital requirement changes for Morgan Stanley and Goldman Sachs.
As you can see above, the error impacted the required common equity tier 1 (CET1) capital ratios of Morgan and Goldman. Closely watched by regulators, the CET1 measures a bank's core capital as a percentage of its risk-weighted assets and serves as a buffer against unexpected loan losses.
Although the changes are small, they can make an impact because these banks hold hundreds of billions in assets. The less regulatory capital banks have to hold, the more they can deploy into assets and securities that generate returns.
Every year, the Fed conducts stress testing, where it projects how the balance sheets of certain banks would fare under hypothetical and typically adverse scenarios categorized by falling GDP and rising unemployment.
This year's stress testing was closely watched by investors because the coronavirus pandemic made some of these once hypothetical scenarios more of a reality. As a result, the Fed ran additional sensitivity analyses to determine how banks might hold up in certain pandemic-related scenarios.
As a result, many banks saw their CET1 ratios requirements increase. No bank saw larger increases than Goldman, whose required CET1 ratio increased from 9.5% to 13.7% before the error, and Morgan Stanley, which saw its required CET1 requirement rise from 8.6% to 13.4% before the error.
The changes are good news for Morgan Stanley, which already was well clear of its required threshold with a 16.1% CET1 ratio at the end of the second quarter. The news will also be welcome by Goldman, who was at a 13.6% CET1 ratio at the end of the second quarter, putting it right on the threshold. Banks that see their CET1 ratios fall below their required minimums can face limits on their capital distributions.
This is not the first time the Fed has had to correct errors in its stress testing. The Fed made an error on its calculations in 2012, according to The New York Times , and in 2019 . But neither impacted banks' capital requirements after the Fed had already issued them.