The Federal Reserve is slated to announce results of its annual bank health check this Wednesday. Also known as ‘stress test’, the results will indicate how much capital large banks need to be healthy.

The annual stress test results also dictate how much banks will return to shareholders in form of dividend payouts and share repurchases. Last year, some notable ones announcing a hike in quarterly dividends were Goldman Sachs (GS Quick QuoteGS - Free Report) , Bank of America (BAC Quick QuoteBAC - Free Report) , Wells Fargo and Morgan Stanley (MS Quick QuoteMS - Free Report) . Surprisingly, JPMorgan (JPM Quick QuoteJPM - Free Report) and Citigroup (C Quick QuoteC - Free Report) had kept dividend payouts unchanged.

Before we start discussing 2023’s hypothetical scenarios and payout expectations from banks, let’s first understand the reason for this annual exercise.

Why Banks Undergo 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 were on the verge of a failure. This compelled the U.S. government to infuse billions of dollars into 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, Bank of America, Wells Fargo, Morgan Stanley, JPMorgan and Citigroup, have been part of this process since the beginning.

The test evaluates whether banks’ capital ratio would remain above the minimum requirement of 4.5% during the hypothetical scenarios. Also, the country’s largest global banks like BAC, JPM, C, GS and MS are required to hold additional ‘G-SIB surcharge’ of at least 1%.

2023 Hypothetical Scenarios

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 – also failed and was acquired by JPMorgan.

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 unemployment rate to touch 10% and a 40% slide in the prices of commercial real estate under severely adverse scenario. Further, equity prices are envisioned to fall 45% and house prices to plunge 38%.

This time, the central bank, added a new "exploratory market shock" for the eight largest banks including JPM, C, GS, BAC and MS. Though this would not impact banks’ capital requirements, it will provide details related to their resilience amid severe market shocks.

How are Banks Expected to Fare?

In 2022, per the Fed, under the 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. All tested banks have an average capital ratio of 9.7%, much above the required minimum of 4.5%.

This time, number of banks undergoing the stress test is 23. The banks with assets between $100 billion and $250 billion are to be tested every alternate year.

Banks are expected to show they have sufficient capital to withstand any fresh turmoil in the industry, despite facing a challenging operating environment and tougher hypothetical scenarios.

But this year’s payouts are likely to be more conservative than 2022 on several headwinds, including ambiguity over the macroeconomic expectations and impending new capital requirement rules.