Big Banks Clear Federal Reserve Stress Tests

by Ike Obudulu Posted on June 21st, 2018

Washington D.C., USA: The nation’s largest bank holding companies are strongly capitalized and would be able to lend to households and businesses during a severe global recession, according to the results of supervisory stress tests released Thursday by the Federal Reserve Board.

The stress test applies synthetic market conditions to the books of large domestic banks in an effort to determine the banks’ stability and ability to repay government loans;

The most severe hypothetical scenario projects $578 billion in total losses for the 35 participating bank holding companies during the nine quarters tested. The “severely adverse” scenario, the most stringent scenario yet used in the Board’s stress tests, features a severe global recession with the U.S. unemployment rate rising by almost 6 percentage points to 10 percent, accompanied by a steepening Treasury yield curve.

The firms’ aggregate common equity tier 1 capital ratio, which compares high-quality capital to risk-weighted assets, would fall from an actual level of 12.3 percent in the fourth quarter of 2017 to a minimum level of 7.9 percent in the hypothetical stress scenario. Since 2009, the 35 firms have added about $800 billion in common equity capital.

“Despite a tough scenario and other factors that affected this year’s test, the capital levels of the firms after the hypothetical severe global recession are higher than the actual capital levels of large banks in the years leading up to the most recent recession,” Vice Chairman Randal K. Quarles said.

Several factors affected the post-stress capital ratios this year. Credit card balances are generally higher, producing increased losses under stress, totaling $113 billion this year. Additionally, recent changes to the tax code affected the firms and the effects were different across the firms. Several firms had immediate, one-time declines in their starting capital ratios because of certain accounting consequences of the tax changes. The tax law also eliminated some beneficial tax treatments that tended to raise post-tax income in times of stress.

Capital is critical to banking organizations, the financial system, and the economy, because it acts as a cushion to absorb losses and helps to ensure that losses are borne by shareholders. The Board’s stress scenarios assume deliberately stringent and conservative hypothetical economic and financial market conditions. The results are not forecasts or expected outcomes.

This is the eighth round of stress tests led by the Federal Reserve since 2009 and the sixth round required by the Dodd-Frank Act. The 35 firms tested this year represent about 80 percent of the assets of all banks operating in the U.S. The Federal Reserve uses its own independent projections of losses and incomes for each firm.

The Dodd-Frank Act stress tests are one component of the Federal Reserve’s analysis during the Comprehensive Capital Analysis and Review (CCAR), which is an annual exercise to evaluate the capital planning processes and capital adequacy of large bank holding companies. CCAR results will be released on Thursday, June 28, at 4:30 p.m. EDT.

Also on Thursday, the Board announced that to be consistent with the recently passed Economic Growth, Regulatory Reform, and Consumer Protection Act, bank holding companies with less than $100 billion in total consolidated assets are no longer subject to supervisory stress testing, including both the Dodd-Frank Act stress tests and CCAR. As a result, the Board will not include CIT Group Inc., Comerica Incorporated, and Zions Bancorporation in this year’s results and future cycles. The Board will have further information on its implementation of the new law at a later date.

The Federal Reserve won’t take any direct action based on the results released Thursday. But they do play a role in how much capital the Fed allows banks to return, and could affect the size of the payouts that banks seek.

Banks have performed strongly in the initial round of stress tests for several years now. In 2017, all firms also passed the more consequential second round, meaning the Fed didn’t have to limit any of the banks’ investor payouts.

Overall, the Fed calculated the largest U.S.-based bank holding companies would have loan losses of $429 billion under a hypothetical scenario that envisioned the U.S. unemployment rate rising to 10% and gross domestic product dropping 7.5%, with a steepening Treasury yield curve.

In contrast, banks are by many measures enjoying their strongest period in a decade. Boosted by a strong economy and busy corporate clients, U.S. banks reported record profits for the first quarter, with $56 billion in net income, according to the Federal Deposit Insurance Corp.

The corporate tax cut in 2017 added about $7 billion to the bottom line for banks in the quarter. But even without that benefit, profit would still be at an all-time high.

The biggest banks in particular are gobbling up market share from struggling overseas rivals and smaller U.S. lenders.

Thanks to a volatile market, stock-trading desks at the big five investment banks — JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Goldman Sachs and Morgan Stanley — had their best start to the year in 2018 in at least a decade.

The Federal reserve recently proposed to replace its static minimum capital ratios, applicable to each of the banks, with a formula that includes a “stress capital buffer,” effectively using a bank’s capital losses from the previous year’s stress test as a metric for how much capital it must retain the following year.

The Federal reserve has also proposed giving banks more insight into how its internal models perform — an idea that critics have charged would be tantamount to “teaching to the test” and that it would water down the stress tests unnecessarily.

The Dodd-Frank Act Stress Test mandated by the 2010 reform law — known as DFAST — precede a separate round of stress tests results expected next week in the Fed’s Comprehensive Capital Analysis and Review, CCAR.

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