If the country were to enter a severe recession, the Federal Reserve projects that the 23 largest banks operating in the U.S. would incur $541 billion of loan losses, for a total projected loss rate of roughly 6.4%. Projected loss rates on commercial real estate (CRE) office properties would be nearly three times higher than what was seen during the Great Recession.
And yet, the biggest banks would hardly flinch, maintaining strong levels of capital despite an incredibly difficult environment.
Given the wave of bank failures earlier this year, the Fed's annual stress test was a worry for many bank management teams. But when the results were released Wednesday, it turned out that, by and large, they had little to fear. Let's see why.
Image source: Getty Images.
How the tests work
Stress testing is an annual exercise conducted by the Fed. It puts the largest and most complex banks in the U.S., like JPMorgan Chase (JPM 0.06%) and Bank of America (BAC -0.21%), through a nine-quarter hypothetical severe economic scenario to see the effects on their balance sheets, capital, profitability, and much more.
The goal is to ensure that the banking system is safe and sound and that banks can continue to lend to individuals, families, and businesses in a difficult economic environment. Stress testing also partially determines bank regulatory capital requirements, which is why investors are always eager to see the results of stress testing. Higher regulatory capital requirements mean lower returns on equity and smaller capital returns, whereas lower capital requirements mean the opposite and are thus positive.
In this year's test, the Fed's hypothetical scenario included unemployment rising from 3.6% to 10% during the stressed time frame, while CRE prices declined by 40%, in addition to a host of other economic challenges.
Breezing through stress testing
During this hypothetical nine-quarter period, bank capital levels held up very well. One key capital ratio that regulators look at during the stress test periods is the common equity tier 1 (CET1) capital ratio, which examines a bank's core capital expressed as a percentage of its risk-weighted assets, such as loans.
During the stressed period, the aggregate CET1 ratio of the 23 banks in this year's test started the period at 12.4% and only hit a low of 10.1%. Banks have a bare minimum CET1 requirement of 4.5%. While no bank would ever want to get nearly that low, 10.1% is quite strong, given the stressed scenario -- keep in mind unemployment is currently below 4%.
Despite what many considered to be a harsher scenario this year, large banks performed better than last year, when the CET1 of all banks tested declined by 2.7% during the stressed period. All banks in this year's stress test also passed on an individual basis, which doesn't always happen.
During the stressed period, the total expected loan loss rate of all 23 banks would hit 6.4%, roughly double the peak loss rate experienced during the Great Recession. The credit card loss rate would hit 17.4%, much higher than what was experienced during the Great Recession, and the loss rate on CRE loans would hit 8.8%.
For the first time ever, the Fed also conducted an exploratory market shock to see how trading and counterparty losses from the eight global systemically important banks would fare under a different economic scenario, where there would be a less severe recession but higher inflation, rising interest rates, a rising dollar, and higher commodity prices. It turns out that the trading and counterparty losses experienced in the exploratory market shock would be similar to or even lower than the original scenario.
How do we reconcile this?
Now, a fair question to ask is: How did banks breeze through stress testing after we had a banking crisis earlier this year that led to the failure of multiple banks? It's an interesting question and one that you'd probably get different answers on.
First, there are some lawmakers and experts who criticize stress testing and believe it is not an accurate representation of what would actually occur if this stressed scenario played out in real life. Others might say the results wouldn't be nearly as bad. In addition, many of these large banks, aside from a few like Credit Suisse, weren't really affected by the banking crisis -- in fact, many benefited.
Furthermore, the banking crisis earlier this year was caused by liquidity issues, whereas annual stress testing focuses more on bank capital. In terms of CRE, the large banks in stress testing only control about 20% of office and downtown CRE loans held by the U.S. banking system, so CRE is really viewed as more of an issue among the community and smaller regional banks.
The Fed's Vice Chair for Supervision, Michael Barr, said in a statement that stress testing is only one way to measure the safety and soundness of the banking system. "We should remain humble about how risks can arise and continue our work to ensure that banks are resilient to a range of economic scenarios, market shocks, and other stresses," Barr added.
With all that said, these results are definitely a win for investors of the large super-regional, investment, and mega banks. There were no major surprises, and a lot of these banks may see lower required capital ratios because of the stress testing results. That potentially means higher capital returns, although there are still other regulatory capital changes that could come this year.
