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Banks Clear 2022 Stress Test: Are Larger Payouts in Store?

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Wall Street’s largest banks are ready to return excess capital to shareholders in the form of dividends and share buybacks after all of them cleared the Federal Reserve’s 2022 Stress Test. The results of the stress test dictate how much capital banks need to be healthy and how much they can return to shareholders.

The annual stress tests were established by the Fed, following the 2008 financial crisis, as a measure to ensure that banks could withstand any similar shock in the future. The balance sheets of major banks like JPMorgan (JPM - Free Report) , Bank of America (BAC - Free Report) , Citigroup (C - Free Report) and Goldman Sachs (GS - Free Report) are tested against an extremely hypothetical economic downturn, the elements of which change annually.

Mainly, there are two hypothetical scenarios — baseline and severely adverse. The baseline scenario includes hypothetical conditions based on average projections from a survey of economic forecasters, whereas the severely adverse scenario has a hypothetical set of conditions to test major banks’ resilience in an adverse economic backdrop, which is characterized by severe global recession, along with heightened stress in commercial real estate and corporate debt markets.

Notably, in 2020, banks faced real-life economic shocks due to the coronavirus pandemic, which, by many measures, were more extreme than the Fed’s hypothetical scenarios. Despite facing a tough operating backdrop, banks were able to clear two rounds of stress tests (in June and December).

Nonetheless, in June 2020, the central bank put limits on banks’ capital distributions (maintaining dividend payouts and suspending repurchases) so that it doesn’t exceed their recent profits. This was done to preserve liquidity due to the economic uncertainty.

This year, all of the 34 biggest lenders that have been tested have cleared the results. The 2022 stress tests’ focus is on an employment crisis that sends the jobless rate to more than 10% for at least two years, plus a 40% drop in commercial real estate prices.

While this year’s scenarios were devised before the Russia-Ukraine conflict and the current red-hot inflation, they indicate that the banks are well-prepared for a potential U.S. recession, which is predicted for later this year or next year.

According to the central bank, under this year’s hypothetical severe downturn, the 34 lenders, which have more than $100 billion in assets, will likely suffer a combined loss of $612 billion.

Still, the banks would have roughly twice the amount of capital with them than required under the rules. According to the test results, all tested banks have an average capital ratio of 9.7%, much above the required minimum of 4.5%. Notably, capital ratios are a measure of how strong a cushion a bank holds against unexpected losses and banks, which perform well typically, stay well above the minimum.

Thus, banks like JPMorgan, Bank of America, Citigroup and Goldman Sachs can use their excess capital to issue dividends and buy back shares. However, any of those plans can be announced after the close of trading on Monday.