US Banks Pass Stress Tests, Demonstrating Resilience in Hypothetical Economic Doomsday Scenario

US banks have successfully passed the annual stress tests conducted by the Federal Reserve, demonstrating their ability to withstand significant losses in a hypothetical doomsday economic scenario. The stress tests revealed that the largest banks in the country could absorb losses amounting to $541 billion while still maintaining sufficient capital reserves.

The passing grades assigned by the Federal Reserve to banks like JPMorgan Chase and Goldman Sachs support the claims made by Wall Street executives and regulators regarding the resilience of systemically important banks in the face of substantial losses.

The stress test results will also impact the capital requirements for banks in the next year. If banks meet or exceed these requirements, they will be exempt from restrictions imposed by the Federal Reserve on the allocation of capital towards shareholder dividends and stock buybacks. Analysts anticipate a decline in the capital requirements for institutions such as Goldman Sachs, JPMorgan, Morgan Stanley, and Bank of America, which has generated optimism for higher dividends or increased share buybacks. As a result, the stocks of these banks experienced a rise of approximately 1.5% in after-hours trading.

The stress test outcomes arrive in the aftermath of three major bank failures in the United States—Silicon Valley Bank, Signature Bank, and First Republic—that triggered a regional banking crisis. However, smaller banks facing pressure from investors following the collapse of Silicon Valley Bank, including PacWest and Comerica, were not included in the stress tests.

Fed Vice-Chair for Supervision, Michael Barr, expressed satisfaction with the results, stating that they confirm the strength and resilience of the banking system. However, he also emphasized that stress tests are just one method of measuring strength, and regulators should remain vigilant about potential risks.

The annual stress tests mandated by the post-2008 Dodd-Frank financial regulations assess whether banks' loss-absorbing capital ratios would remain above the minimum requirements in the event of an economic catastrophe. This year's stress test evaluated banks' ability to withstand a peak unemployment rate of 10%, a 40% decline in commercial real estate prices, a 38% drop in house prices, and short-term interest rates approaching zero.

Among the 23 banks tested, Deutsche Bank's US subsidiary experienced the most significant capital hit, followed by UBS Americas. Goldman Sachs and Morgan Stanley, both headquartered in the US, witnessed the largest declines in capital levels due to their greater exposure to trading, which is considered riskier by the Federal Reserve.

Despite projected losses of $541 billion, all tested banks, including Bank of America, Citigroup, State Street, and Wells Fargo, would meet the minimum capital requirements. These projected losses comprised $424 billion from loan losses and $94 billion from trading and counterparty losses.

The stress test results will assist in determining the stress-test capital buffer for each bank, representing the amount of common equity tier one capital they must hold above regulatory minimums relative to their risk-weighted assets. Banks will publicly disclose their indicative stress-capital buffer and may reveal potential buyback or dividend plans starting from Friday.

Later this summer, the Federal Reserve and other US banking regulators are expected to publish new international standards, known as the Basel III endgame rules, for calculating risk-weighted assets. Analysts and bank executives anticipate that these rules, aligning the US with international standards, will require American banks to hold more common equity tier one capital.

The Financial Services Forum, a lobbying group representing the largest US banks, stated that the stress test results underscore the sufficiency of banks' capital and argued against the need for stricter requirements, affirming that the post-Dodd-Frank reforms have successfully achieved the goal of a stronger and safer banking system.

US regulators are also planning to expand the new Basel rules to include mid-sized banks similar in size to Silicon Valley Bank, Signature Bank, and First Republic. The scrutiny of the list of banks subject to the Federal Reserve's stress tests has intensified following the failure of Silicon Valley Bank due to its exposure to significant interest rate risk.

Although Silicon Valley Bank would not have undergone stress tests until 2024 under the current rules, it might have passed even if it had been included, as the scenario did not account for the sharply higher interest rates that led to the bank's downfall.

By fLEXI tEAM