© Reuters. A cyclist passes the Federal Reserve Building in Washington, D.C., US, August 22, 2018. REUTERS/Chris Watty
Written by Pete Schroeder
WASHINGTON (Reuters) – The Federal Reserve is scheduled to release the results of its annual bank health checks on Wednesday, June 28. Items that change annually.
The results determine how much capital banks need to be healthy and how much they can return to shareholders through share buybacks and dividends.
Why is the Fed doing a “stress test”?
The Fed created the tests in the aftermath of the 2007-2009 financial crisis as a tool to ensure that banks can withstand a similar shock in the future. Examinations officially began in 2011, and the top lenders initially struggled to earn passing scores.
Citigroup (NYSE:), Bank of America (NYSE:), JPMorgan Chase & Co (NYSE:), and Goldman Sachs Group (NYSE:), for example, has had to adjust capital plans to address the Fed’s concerns. Deutsche Bank The US subsidiary ETR failed in 2015, 2016 and 2018.
However, years of practice have made banks more adept at testing, and the Federal Reserve making testing more transparent. He ended much of the exam drama by scrapping the “success” model and introducing a more refined, ad hoc capital system.
So how are banks rated now?
The test assesses whether banks will stay above the required minimum capital ratio of 4.5% during a hypothetical downturn. Banks with strong performance usually remain much higher. The country’s largest international banks must also carry a “G-SIB surcharge” of at least 1%.
How well a bank does on the test also determines the size of the “squeeze capital reserve,” an extra layer of capital introduced in 2020 that sits above the 4.5% minimum.
This additional protection is determined by each bank’s default losses. The higher the losses, the larger the buffer.
role
The Fed will release results after the markets close. It typically publishes aggregate industry losses, and individual bank losses including details of how specific portfolios – such as credit cards or mortgages – are performing.
The Fed does not allow banks to announce their dividend and buyback plans until a few days after the results are in. It announces the amount of precautionary capital for each bank in subsequent months.
The country’s largest lenders, notably JPMorgan Citigroup, Wells Fargo (NYSE:) & Co, Bank of America, Goldman Sachs, and Morgan Stanley (NYSE:) is watching the markets closely.
hard test?
The Fed changes scenarios every year. They take months to create, which means they run the risk of becoming obsolete. In 2020, for example, the real economic collapse caused by the COVID-19 pandemic was more severe by many measures than the Fed scenario that year.
The tests of 2023 were set before this year’s banking crisis in which a Silicon Valley bank and two other lenders failed. And they found themselves in the wrong position of interest rate hikes by the Fed, suffering large unrealized losses on their holdings of US Treasuries, which spooked uninsured depositors.
The Fed has been criticized for not testing banks’ balance sheets against an environment of rising interest rates, assuming instead that rates will fall amid a severe recession.
However, the 2023 test is expected to be more difficult than in previous years because the actual economic basis is more sound. This means that the spikes in unemployment and declines in the size of the economy under test become more severe.
For example, the 2022 stress test envisioned a 5.8 percentage point jump in the unemployment rate under a “extremely adverse” scenario. In 2023, that increase is 6.5 percentage points, thanks to an increase in hiring over the past year.
As a result, analysts expect banks to be required to allocate slightly more capital than they would have in 2022 to account for expected growth in typical losses.
Stresses in commercial real estate and corporate debt
The test also envisions a 40% drop in commercial property prices, an area of greater concern this year as pandemic-era office vacancies stress borrowers.
In addition, banks with large trading operations will be tested against the “global market shock”, and some will also be tested against the failure of a larger counterparty.
For the first time, the Fed will also conduct an additional “exploratory market shock” against the eight largest and most complex companies, which will be another sharp decline but with slightly different characteristics.
This additional test will not count towards banks’ capital requirements, but will allow the Fed to explore the application of multiple adverse scenarios in the future. Fed Vice Chairman of Supervision Michael Barr said several scenarios could make the tests better at detecting banks’ vulnerabilities.
What companies have been tested?
In 2023, 23 banks will be tested. That’s down from the 34 banks in 2022 the Fed decided in 2019 to allow banks with $100 billion to $250 billion in assets to test every two years.