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Banks to be Conservative Despite Passing 2023 Stress Test
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At a time when the macroeconomic backdrop is a bit challenging for the banking industry, all 23 participating banks passed the Federal Reserve’s latest annual health check, also known as the ‘stress test.’ This means that these banks will be able to withstand a severe global recession.
The stress test results indicate how much capital large banks need to be healthy. It also dictates how much banks will return to shareholders in the forms of dividend payouts and share repurchases.
Need for the Annual Stress Test
The annual stress tests are authorized under the Dodd-Frank financial-services law and conducted every year since 2009.
The tests were introduced in the aftermath of the 2008 financial crisis when big financial institutions like Lehman Brothers collapsed and several other large banks like Bank of America (BAC - Free Report) were on the verge of failure. This compelled the U.S. government to infuse billions of dollars into the credit markets and save the entire financial system from crashing.
The stress tests evaluate banks' capital adequacy, liquidity and risk management practices under adverse hypothetical scenarios, such as a deep recession or a sharp decline in asset prices. Large banks, including Goldman Sachs (GS - Free Report) , Bank of America, Wells Fargo, Morgan Stanley, JPMorgan (JPM - Free Report) and Citigroup (C - Free Report) , have been part of this process from the beginning.
The test evaluates whether banks’ capital ratio will be above the minimum requirement of 4.5% during some hypothetical scenarios. The country’s largest global banks like BAC, JPM, C, GS and Morgan Stanley are required to hold an additional ‘G-SIB surcharge’ of at least 1%.
Hypothetical Scenarios for 2023
The Fed changes the scenarios every year.
This year’s hypothetical scenarios were devised before the banking turmoil began with the collapse of Silicon Valley Bank and Signature Bank in March. Since then, a third large bank — First Republic Bank — failed and was acquired by JPMorgan.
A severely adverse scenario “is characterized by a severe global recession, with prolonged declines in both residential and commercial real estate prices, which spill over into the corporate sector and affect investment sentiment.” This time, the Fed envisaged the unemployment rate to touch 10% and a 40% slide in the prices of commercial real estate under the severely adverse scenario. Further, equity prices were envisioned to fall 45% and house prices to plunge 38%.
This time, the central bank added a new scenario, wherein the eight banks with large trading operations were tested against a “global market shock” and the trading books of these banks were tested against a second “exploratory market shock.”
The global market shock was a severe recession with fading inflation expectations, whereas the exploratory market shock tested a less severe recession with greater inflationary pressures.
A Little on This Year’s Results
Results from the stress test show that the 23 participating banks have enough capital to absorb the $541-billion projected losses on loans and other positions.
The $541 billion comprises $424 billion in loan losses; $18 billion in additional losses from items such as loans booked under the fair-value option; $94 billion in trading and counterparty losses at the 11 banks with substantial trading, processing or custodial operations; and the remaining $5 billion in securities losses.
While all banks passed the test, the performance of each varied drastically under the ‘severely adverse scenario.’ The banking giants posted the biggest projected net income losses, led by Citigroup’s projected loss of $34.9 billion. This was followed by WFC with $32.9 billion and JPMorgan with $30.1 billion.
Goldman Sachs had the highest amount of estimated losses from commercial estate loans and credit cards. GS also had the highest projected loss under the "global and exploratory market shock" scenario.
The mid-sized banks took greater hits to their capital ratios than the average across all the banks.
Regional banks, including U.S. Bancorp, Truist Financial Corporation, Citizens Financial Group and Capital One Financial Corporation (COF - Free Report) , had the lowest stressed capital levels, ranging between 6% and 8%.
The biggest loan loss rate of 14.7% was suffered by COF. The lowest loan loss rate of 1.3% was for Charles Schwab. In addition to the lowest loan loss rate, SCHW had the highest capital buffer.
Michael Barr, the vice chair for supervision at the Fed, stated, “Today’s results confirm that the banking system remains strong and resilient.”
However, unlike previous years, just clearing the 2023 stress test requirements is not enough for banks this time.
Some increased regulations on regional banks are expected in the coming months because of their recent failures. Also, tighter international standards are expected for the largest banks to boost capital requirements.
Thus, banks, which are expected to disclose their plans for buybacks and dividends on Friday, will likely be more conservative this time because of the uncertainties regarding the upcoming regulations and the risks of a recession hitting next year.
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Banks to be Conservative Despite Passing 2023 Stress Test
At a time when the macroeconomic backdrop is a bit challenging for the banking industry, all 23 participating banks passed the Federal Reserve’s latest annual health check, also known as the ‘stress test.’ This means that these banks will be able to withstand a severe global recession.
The stress test results indicate how much capital large banks need to be healthy. It also dictates how much banks will return to shareholders in the forms of dividend payouts and share repurchases.
Need for the Annual Stress Test
The annual stress tests are authorized under the Dodd-Frank financial-services law and conducted every year since 2009.
The tests were introduced in the aftermath of the 2008 financial crisis when big financial institutions like Lehman Brothers collapsed and several other large banks like Bank of America (BAC - Free Report) were on the verge of failure. This compelled the U.S. government to infuse billions of dollars into the credit markets and save the entire financial system from crashing.
The stress tests evaluate banks' capital adequacy, liquidity and risk management practices under adverse hypothetical scenarios, such as a deep recession or a sharp decline in asset prices. Large banks, including Goldman Sachs (GS - Free Report) , Bank of America, Wells Fargo, Morgan Stanley, JPMorgan (JPM - Free Report) and Citigroup (C - Free Report) , have been part of this process from the beginning.
The test evaluates whether banks’ capital ratio will be above the minimum requirement of 4.5% during some hypothetical scenarios. The country’s largest global banks like BAC, JPM, C, GS and Morgan Stanley are required to hold an additional ‘G-SIB surcharge’ of at least 1%.
Hypothetical Scenarios for 2023
The Fed changes the scenarios every year.
This year’s hypothetical scenarios were devised before the banking turmoil began with the collapse of Silicon Valley Bank and Signature Bank in March. Since then, a third large bank — First Republic Bank — failed and was acquired by JPMorgan.
A severely adverse scenario “is characterized by a severe global recession, with prolonged declines in both residential and commercial real estate prices, which spill over into the corporate sector and affect investment sentiment.” This time, the Fed envisaged the unemployment rate to touch 10% and a 40% slide in the prices of commercial real estate under the severely adverse scenario. Further, equity prices were envisioned to fall 45% and house prices to plunge 38%.
This time, the central bank added a new scenario, wherein the eight banks with large trading operations were tested against a “global market shock” and the trading books of these banks were tested against a second “exploratory market shock.”
The global market shock was a severe recession with fading inflation expectations, whereas the exploratory market shock tested a less severe recession with greater inflationary pressures.
A Little on This Year’s Results
Results from the stress test show that the 23 participating banks have enough capital to absorb the $541-billion projected losses on loans and other positions.
The $541 billion comprises $424 billion in loan losses; $18 billion in additional losses from items such as loans booked under the fair-value option; $94 billion in trading and counterparty losses at the 11 banks with substantial trading, processing or custodial operations; and the remaining $5 billion in securities losses.
While all banks passed the test, the performance of each varied drastically under the ‘severely adverse scenario.’ The banking giants posted the biggest projected net income losses, led by Citigroup’s projected loss of $34.9 billion. This was followed by WFC with $32.9 billion and JPMorgan with $30.1 billion.
Goldman Sachs had the highest amount of estimated losses from commercial estate loans and credit cards. GS also had the highest projected loss under the "global and exploratory market shock" scenario.
The mid-sized banks took greater hits to their capital ratios than the average across all the banks.
Regional banks, including U.S. Bancorp, Truist Financial Corporation, Citizens Financial Group and Capital One Financial Corporation (COF - Free Report) , had the lowest stressed capital levels, ranging between 6% and 8%.
The biggest loan loss rate of 14.7% was suffered by COF. The lowest loan loss rate of 1.3% was for Charles Schwab. In addition to the lowest loan loss rate, SCHW had the highest capital buffer.
Michael Barr, the vice chair for supervision at the Fed, stated, “Today’s results confirm that the banking system remains strong and resilient.”
However, unlike previous years, just clearing the 2023 stress test requirements is not enough for banks this time.
Some increased regulations on regional banks are expected in the coming months because of their recent failures. Also, tighter international standards are expected for the largest banks to boost capital requirements.
Thus, banks, which are expected to disclose their plans for buybacks and dividends on Friday, will likely be more conservative this time because of the uncertainties regarding the upcoming regulations and the risks of a recession hitting next year.