Fed says banks can withstand 10% unemployment and 55% share price drop in annual stress test

The Federal Reserve Board on Thursday projected the potential for a harder path for banks than a year ago, but said the 33 financial institutions it analyzed had passed its annual stress test of capital reserves.

The Fed estimated $612 billion in potential losses for banks in their worst economic scenario and said that even if that happens, banks will still be healthy enough to provide loans to homes and businesses to keep the economy afloat. . That’s a more severe loss projection of $50 billion than a year ago by the biggest banks.

“This year’s what-if scenario is tougher than the 2021 test, by design, and includes a severe global recession,” the Fed said in a statement.

The Fed’s model included a 5.75% rise in unemployment to 10%, a 40% drop in commercial real estate prices and a 55% drop in stock prices.

Under these conditions, the aggregate common equity ratio – a hedge against losses – would drop 2.7% to a low of 9.7%, which is double the minimum requirement. In 2021, the projected decline in the aggregate common equity ratio was 2.4%.

After the test results, banks will be cleared to announce dividends and share buybacks from Monday after the market closes.

Federal Reserve officials emphasized that the economic slowdown in the stress test is not a projection of how they expect the economy to actually work, but rather a hypothesis for measuring the strength of banks.

The stress test also assumed more than $450 billion in loan losses and $100 billion in trade and counterparty losses.

The banking system also has limited exposure to losses in cryptocurrency markets and is expected to remain resilient despite the turmoil in this sector, Fed officials said.

The banking system started the year with an aggregate common capital ratio of 12.4%. It fell slightly in 2022 but remains well above historic levels, such as 5% in 2009 and around 10% in 2012, according to Fed data.

The stress tests cover the largest US banks, including JPMorgan Chase & Co. JPM,
Goldman Sachs Group Inc. GS,
American Express Co. AXP,
Morgan Stanley MS,
Wells Fargo & Co. WFC,
Bank of America Corp. BAC,
and Citigroup Inc. Ç,
as well as regional creditors.

Ahead of the results, bank stocks were mostly lower as Fed Chair Jerome Powell testified for a second day before Congress and reiterated his commitment to fighting inflation.

JPMorgan Chase was down 1.1%, Goldman Sachs was up 0.6%, Citigroup was down 1.8% and Bank of America lost about 1.6%. The Selected Financial Sector SPDR ETFS XLF,
dropped 0.4%.

Stress tests measure balance sheets against capital requirements for banks as an indicator of their strength in a potential economic downturn. The results then shape how much capital banks will return to shareholders in the form of buybacks and dividends.

Ahead of the stress test results, Cowen analyst Jaret Seiberg said on Thursday he hoped the banks would pass but warned of a possible backlash from lawmakers.

“The political risk today is that Capitol Hill will question why banks should distribute any capital if a recession is possible,” Seiberg said. “We don’t see it winning the day, but it could draw attention.”

Capital Alpha’s Ian Katz said he expects some potential “bumps” given the greater number of banks undergoing stress tests this year.

“This year’s tests are considered to be a little more difficult than last year’s,” Katz said in a research note. “For example, the global market shock element of the scenarios can pose challenges for banks with a lot of international exposure.”

The latest results reflect the Fed’s assessment of 33 US banks, up from 23 lenders last year. Banks with less than $250 billion in assets take the exam every two years instead of every year, under rules adopted in 2020. Large regional banks such as Fifth Third Bancorp FITB,
and Ally Financial Inc. ALLY,
were included this year after the 2021 withdrawal.

The US Federal Reserve reformulates the test conditions each year depending on the key economic factors on the central bank’s radar screen.

To see: Powell says US economy can handle additional rate hikes coming

Thursday’s stress test results mark the latest round of exams dating back to the Dodd-Frank banking reform legislation that followed the 2008 global financial crisis.

In 2021, the Fed said 23 of the biggest banks operating in the US would still hold more than twice as much capital, even with $474 billion in losses in a potential recession. That conclusion led the Fed to lift the restrictions on buybacks and dividends it introduced in response to the COVID-19 pandemic.

Read too: US banks to pay an extra $2 billion in quarterly dividends after Fed green light

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