On Thursday, the Federal Reserve reported that every participating bank passed the 2015 stress tests, paving the way for the nation's biggest lenders to increase their dividends and/or share buybacks over the next 12 months.
The tests are designed to do one thing: Determine whether systematically important financial institutions (banks in particular) have enough capital to sustain an economic shock akin to the financial crisis of 2008-2009.
The Fed does this by modeling what would happen to bank capital under two hypothetical scenarios, the most extreme of which (the "severely adverse" scenario) assumes unemployment would rise to 10%, stocks would fall by 60%, and housing values would drop by 25%, among other things.
As you can see in the chart below, even under these stringent conditions, the Fed predicts that all of the banks examined could maintain a Tier 1 common capital ratio above the 5% regulatory minimum:
The drop in bank capital doesn't materialize out of thin air; it derives instead from the Fed's projections about how much money lenders would earn or lose over the hypothetical two-year crisis.
On one end of the spectrum are massive financial institutions including JPMorgan Chase, Citigroup, and Bank of America, which are projected to lose a cumulative $140.6 billion over the course of the imagined crisis. On the other end are a couple regional lenders, two credit card companies, and the nation's two biggest custodial banks, which would hypothetically earn money despite the projected downturn.
Finally, while many of these banks would experience losses from a variety of sources, including their trading operations and securities portfolios, the lion's share of industrywide damage would come from loan losses.
Here's how the Fed expects those losses to break down by loan type amid the "severely adverse" scenario:
This year's stress test results unquestionably point to a recovering industry, as this was the first year that no bank failed to maintain a sufficient amount of capital even at the nadir of the hypothetical crisis.
Next up is the comprehensive capital analysis and review, which determines whether these same banks can increase the amount of capital they return to shareholders over the next 12 months. The CCAR results are due out on March 11.
