The U.S Federal Reserve is expected to announce the results of its annual bank health checks on Thursday. Under the “stress test” exercise, the Fed analyzes banks’ balance sheets against a hypothetical extreme economic slowdown, the elements of which vary annually.
These results determine how much capital banks require to be healthy and how much they can pay back to shareholders via dividends and share buybacks.
WHY DOES THE FED “STRESS TEST” BANKS?
The Fed designed the tests after the 2007- 2009 financial crisis as a tool to make sure banks could survive a similar shock in the future. The tests formally started in 2011, and large lenders initially strained to acquire passing grades.
JPMorgan Chase & Co (JPM.N), Goldman Sachs Group Inc (GS.N), Citigroup Inc (C.N), and Bank of America Corp. (BAC.N), for instance, had to alter their capital plans to deal with the Fed’s concern. Deutsche Bank’s U.S. subsidiary was unsuccessful in 2015, 2016, and 2018 on the “qualitative” aspect of the test, which analyzed banks’ operational controls.
However, years of practice have made lenders more skillful at navigating tests and under its former Republican leadership the Fed made the tests more direct and left out the “qualitative” aspect. It also stopped much of the drama of the tests by eliminating the “pass-fail” model and developing a more nuanced, bank-specific capital regime.
SO HOW ARE BANKS ASSESSED NOW?
The test analyzes whether banks would remain above the required 4.5% minimum capital ratio during the hypothetical slowdown. Banks that are successful normally remain well above it. How well a bank does on the test also determines the size of its “stress capital buffer,” an extra layer of capital initiated in 2021 which is above the 4.5% minimum.
That additional cushion is decided by every bank’s hypothetical losses. The greater the losses, the greater the buffer.
The Federal Reserve will disclose the results after market close on June 30. It normally announces each bank’s capital ratios and total losses under the test, with details on how their individual portfolios – like mortgages or credit cards – fared.
Banks are not permitted, however, to reveal their plans for buybacks and dividends before next Monday, June 27. The Fed will publish the size of every bank’s stress capital buffer in the months to come.
The country’s major lenders, particularly JPMorgan, Goldman Sachs, Citi, Morgan Stanley, Wells Fargo & Co (WFC.N), and Bank of America are closely-monitored by the markets.
A TOUGHER TEST?
The Fed alters the scenarios every year. They take months to design, which means they risk becoming obsolete. In 2021, for instance, the real economic crunch triggered by the COVID-19 pandemic was by many measures more intense than the Fed’s scenario that year.
The Fed designed 2022’s scenario in advance of Russia’s invasion of Ukraine and the current hyper-inflationary outlook.
Nevertheless, this year’s test is seen to be more complicated than 2021’s because the actual economic baseline is healthier. That means a severe contraction in the size of the economy and a jump in unemployment rate under the test are felt more severely.
For instance, last year’s stress test forecasted a 4% spike in unemployment under a severely adverse” scenario. This year, that jump is 5.75%, caused mainly by increasing employment over last year.
As a result, analysts believe banks will be told to reserve slightly more capital than last year to account for anticipated growth in modeled losses.
STRESSES IN COMMERCIAL REAL ESTATE, CORPORATE DEBT
This year, the test will also include “heightened stress” in commercial real estate, which was shocked by the pandemic as employees were sent home, and corporate debt markets. Global watchdogs, including the International Monetary Fund, have cautioned of increased levels of risky corporate debt as interest rates grow globally.
ALL BANKS TESTED
This year, all 34 U.S. banks tracked by the Fed with over $100 billion in assets will take the stress test, in comparison to 23 lenders in 2021.
The reason behind it is that the Fed agreed to a new standard in 2021 that demanded that banks with less than $250 billion in assets only have to undergo the test every other year. That means that top regional banks, like Fifth Third Bancorp (FITB.O) and Ally Financial Inc (ALLY.N) take the test again after a year off.