Massive financial institutions could experience estimated losses of $685 billion according to the Federal Reserve's stress test analysis.
In a recent stress test conducted by the Federal Reserve, eight of the largest banks in the US faced an additional challenge. The test, which simulated an economic downturn, revealed potential losses of $70 billion to $85 billion if five large hedge funds were to implode.
The results of the stress test showed an average decline of 2.8 percentage points in capital levels for the participating banks compared to 2018. This decline primarily reflects the impact of more severe and complex economic stress scenarios tested over time, along with evolving capital measurement methodologies and regulatory adjustments.
The Federal Reserve's stress tests have progressively incorporated harsher economic conditions, including deep recessions, market volatility, and increased geopolitical and financial system risks. This expansion of stress scenarios results in banks projecting larger losses and thus lower capital ratios under stress conditions than in earlier years with less severe scenarios.
Over time, the Fed has refined and sometimes tightened the stress test framework, including changes in how certain risks are measured or capital requirements calculated. These amendments can inherently reduce projected capital levels as the tests become more granular or demand greater capital buffers for identified risks.
Banks' exposures to certain risk areas, such as market risk, counterparty credit risk, and vulnerabilities to non-bank financial institutions, have heightened. These amplified risks lower stressed capital levels across scenarios.
Real-world changes, such as the winding down of risky asset holdings or evolving macroeconomic conditions, also influence banks’ loss estimates in stress tests.
Despite the decline in capital levels, every tested bank maintained more than the 4.5% minimum capital buffer required in the test. Some banks fared better than others, with BMO coming closest to the minimum at 5%, followed by Citizens and HSBC, with 6.5% and 6.7%, respectively.
Notable losses were seen in commercial real estate loan books, with Goldman Sachs seeing the greatest losses among tested banks at 15.9%. Credit card delinquencies would account for $175 billion in theoretical losses to the larger field of 31 banks, with Ally seeing the largest losses of any tested bank at 40.6%.
JPMorgan Chase stated that the Fed overestimated its "other comprehensive income." If JPMorgan's analysis is correct, it may take more time for the bank to finalize its plans to deliver dividends or repurchase stock. Citi's internal stress test last year predicted $64.4 billion of non-interest income over nine quarters, while the Fed forecast $43.9 billion. By Citi's calculations, the bank's capital ratio would have been 10.6%, rosier than the 9.1% the Fed estimated.
Rob Nichols, CEO of the American Bankers Association, stated that the continued strength and resilience of the banking sector is further evidence that the recent tsunami of new regulation, including proposed higher capital standards, is unwarranted. Kevin Fromer, CEO of the Financial Services Forum, also expressed his view that the additional capital requirements in the Basel III Endgame proposal are not justified.
Chris Marinac, director of research at Janney Montgomery Scott, expressed positivity with the results, stating that he expected losses to be slightly higher, especially in areas such as commercial real estate. Matthew Bisanz, a partner in the financial services practice at law firm Mayer Brown, expressed concerns about the stress tests' reliance on capital buffers, stating that they make the tests "unrealistic."
Overall, the Federal Reserve's annual stress test reveals that all participating banks have enough capital to endure a scenario with a 10% unemployment rate, 36% house price decline, and 40% commercial real estate price plunge. The Fed official's statement to The New York Times is that the stress test results will not change the central bank's plans to implement revamped capital requirements for the U.S.'s largest banks.
Sources:
- Federal Reserve's 2023 stress test results
- "Fed stress tests: How the scenarios have changed over time" - American Banker
- "Stress testing banks: A guide for non-experts" - Federal Reserve Bank of New York
- "The Federal Reserve's stress tests: A balancing act" - The Wall Street Journal
The stress test results indicate that the banking-and-insurance sector, including business establishments like JPMorgan Chase and Citigroup, faced potential losses due to adverse economic conditions. The industry's financial health remains robust as every tested bank maintained more than the minimum capital buffer, despite slightly lower capital levels when compared to 2018.
