In a recent demonstration of strength, the 31 large US banks that participated in a Federal Reserve stress test have shown that they would all be able to withstand a severe global recession. This is reassuring news as they oppose stricter regulations that would mandate them to hold more capital.
The results of the stress test, released by the Fed, indicate that these banks have enough capital on hand to absorb losses and continue lending even in a scenario where US unemployment reaches 10%, commercial real estate prices drop by 40%, and the stock market plunges by 55%. In this extreme situation, the banks collectively faced losses amounting to $685 billion, with significant proportions coming from credit cards, business loans, and commercial real estate.
Notably, leading institutions such as JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs, and Morgan Stanley all maintained capital buffers nearly double the Fed’s minimum requirement of 4.5% under this stress scenario. Similarly, larger regional banks like PNC, Truist, Regions, Citizens, and M&T Bank also exhibited higher capital levels compared to the minimum threshold.
However, despite the overall positive outcome, there were indications of new weaknesses among some banks. The decline in capital ratios during a hypothetical downturn was higher than in the previous year’s test, reflecting riskier bank balances and increased expenses. Factors such as rising credit card balances, riskier corporate credit portfolios, and reduced income from higher expenses and lower fee revenue contributed to this capital decline.
Results varied across institutions, with Discover and Capital One having the highest rates of loan losses under the severely adverse scenario, while Charles Schwab experienced the lowest losses. Notably, Capital One had agreed to acquire Discover earlier this year pending regulatory approval.
Since the last financial crisis, the Fed has been applying stress tests annually to banks with more than $100 billion in assets to help ensure their stability. A recent law tailored the tests by banks’ size, with institutions in the $100 billion-$250 billion range now being tested every other year. This adjustment was met with criticism by some Democrats and regulators, who argued that stress tests could have potentially prevented the failure of Silicon Valley Bank in 2023.
Banks typically use the results of stress tests to determine their capital allocation for absorbing shocks and for dividends and buybacks. Some banks are expected to announce their plans for returning money to shareholders soon, although these moves are likely to be modest until regulators provide clarity on proposed new capital requirements, which have faced pushback from banks.
Nevertheless, regulators have hinted at adjustments to the proposal, potentially reducing capital hikes from the initial 16% aggregate level. Speculation suggests that the new proposal could see capital hikes as low as 5%.
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