The Federal Reserve Board (the Fed) released results of its annual bank stress tests on June 23, 2022. The tests are intended to measure banks’ capability to maintain sufficiently strong capital levels to enable continued lending to businesses and households during a recession.
The stress tests seek to ensure that banks can continue to support the economy during any economic downturns. The tests evaluate the resilience of large banks, estimating their capital levels, losses, revenue and expenses over a nine-quarter horizon.
The scenario considered in this year’s stress tests is more severe than any post-World War II recession, including the 2007–2009 global financial crisis. This year’s stress scenario assumed:
- falling asset prices (equity prices fall 55%, accompanied by a rise in VIX)
- 5¾-percent increase in the unemployment rate
- 3½-percent decline in real GDP
- 40% drop in commercial real estate prices
- 28% decline in house prices
- 55% decline in the stock market
Despite a sharp deterioration in economic and financial conditions assumed in this year’s stress test scenario, it appears all banks remained above minimum capital requirements. Furthermore, the stress applied remains far beyond the decline of the market conditions we are currently facing in this macro environment.
The stress applied considered a market drop of more than 30%, which is the current decline since Q4 2021, showing the Fed used assumptions that are comparable to today’s financial climate. Under the stress scenario, aggregated common equity tier 1 capital ratio (CET1 Ratio), which provides a cushion against losses, is projected to decline by 270 bps to a minimum of 9.7% (double the minimum requirement), for a total projected loss of $612 billion. Additionally, the aggregate 2.7 percent decline in capital is slightly larger than the 2.4 percent decline from last year's test but is comparable to recent years.
Total of 34 banks for aggregated ratios. CET1 ratio for 2022 Severely adverse scenario is 9.7% which is more than double the minimum regulatory capital requirement and slightly lower than Actual Q4 2021 and 2021 Adverse scenarios
For the banks subjected to global market shocks, the more severe shocks in this year’s scenario drove increased trading and counterparty losses, which is generally in line with previous years. In addition, the Fed has also tested the banks’ resilience to rising interest rates through higher Treasury rates and MBS spreads in this year’s global market shock to ensure it’s in line with economic trends.
The tougher assumptions in this year’s stress scenario resulted in higher projected loan losses compared to last year’s stress tests. Total losses were largely driven by more than $450 billion in loan losses and $100 billion in trading and counterparty losses.
For 2022, the larger banks saw an increase of over $50 billion in losses compared to the 2021 tests, while pre-provision net revenue projections rose compared to last year’s test. The increase in banks’ balance sheets during the pandemic continued to cause the Fed’s projections to overstate noninterest expenses (including losses from operational-risk events) and a few fee income components. Lower allowances for credit losses at the start of the stress tests further raised projected provisions for loan losses.
Individual bank results from the stress test will factor directly into a bank's capital requirements, mandating each bank to hold enough capital to survive a severe recession. At this point, given the rise in interest rates and inflation coming out of the COVID environment, there is some ambiguity about the implications for the second half of 2022. If an institution cannot stay above its minimum capital requirements, it is subject to automatic restrictions on capital distributions and discretionary bonus payments. This will not create concern for regulators but will for investors and shareholders alike.
The results that we have outlined will most likely translate into higher stress capital buffer requirements for US banks. While the terms of the tests were announced in February 2022 before US inflation surged to a 40-year high, the scenarios do not seem far off amid current concerns of a global economic slowdown. Large banks passing the stress tests will be able to issue dividends and share buybacks.