The Federal Reserve recently released its hypothetical scenarios for 2023 bank stress testing. Every year, the Fed puts the largest, most complex, and systemically important banks through a hypothetical set of adverse economic scenarios to see how bank balance sheets and capital levels would hold up.
Introduced as part of Dodd-Frank legislation following the Great Recession in 2007-09, the goal of stress testing is to make sure banks can withstand a severe economic shock and still be able to lend to individuals, families, and businesses. But investors also watch stress testing because it plays a key part in determining bank capital requirements. The more capital banks hold, the weaker their returns are and the less capital they can return to shareholders.
In this year's stress-testing scenario, the Fed threw banks another curveball. Let me explain.
A harsher scenario
Stress testing is modeled over a nine-quarter period. In this year's severely adverse scenario, the Fed has unemployment rising from its current level of 3.5% all the way to 10% by the third quarter of 2024, while real gross domestic product (GDP) would fall by 8.75%. Meanwhile, equity prices would drop by 45%, home values would decline by 38%, and commercial real estate prices would decline by 40%.
Also, interestingly, in the Fed's hypothetical scenario the Chicago Board Options Exchange's CBOE Volatility Index, which is also known as the "fear gauge" and looks at the market's near-term expectations for volatility, would shoot up and peak at 75. This is right around levels seen in the Great Recession and the very beginning of the pandemic.
The Fed's 2023 scenario is more severe than last year. Stress testing for the first time also includes an "additional exploratory market shock" for the trading operations of eight of the global systemically important banks (GSIB).
The eight banks that will undergo the exploratory shock are JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Morgan Stanley, Goldman Sachs, Bank of New York Mellon, and State Street. While the results of this new test will not be used for determining bank capital requirements this year, it's possible that multiple scenarios could be used in future stress testing.
Capital requirements likely to move higher
This year marks the first stress test under the Fed's new Vice Chair for Supervision, Michael Barr, who has previously advocated for higher capital requirements.
Bank stress testing helps determine each bank's capital requirements for the following year, namely the common equity tier 1 (CET1) capital ratio, which essentially measures a bank's core capital expressed as a percentage of its risk-weighted assets such as loans. The capital that a bank has above its CET1 requirement can be used for dividends and share repurchases. Stress testing helps set the middle layer, the stress capital buffer (SCB), in the CET1 ratio, which is composed of three parts.
Image source: Federal Reserve.
In the nine-quarter stress test period, the Fed looks at a bank's beginning CET1 ratio and the lowest point of the CET1 ratio during the nine-quarter stressed period as the bank absorbs the shock. The difference between the two numbers plus four quarters of dividends equals the SCB. The Bank Policy Institute, a non-partisan public policy group, expects the aggregate CET1 ratio of all banks tested to fall slightly more in the Fed's 2023 hypothetical scenario than it did during last year's test. If this does happen, it will be the fourth consecutive year the aggregate SCB increased.
So what does this all mean?
Banks are likely looking at higher CET1 requirements toward the end of 2023 and into 2024. Not only will many banks likely see a slight uptick in their SCB but the long-awaited finalization of international and U.S. regulatory capital rules could also lead several banks to face higher GSIB surcharges, which is the top layer of the CET1 ratio.
All of this points to potentially less capacity for share repurchases because banks may need to build capital. They are more than capable of doing this but it can take time, during which share repurchases will slow, and banks ultimately may not end up having as much excess capital as they've had in the past.
