On Wednesday, the Federal Reserve released the results of its annual bank stress test, which shows that large banks are well positioned to weather a severe recession and continue to lend to households and businesses even during a severe recession.
“Today’s results confirm that the banking system remains strong and resilient,” said Vice President of Supervision Michael S. Barr. “At the same time, this stress test is only one way to measure that strength. We must remain humble about how risks arise and continue our work to ensure banks are resilient to a range of economic scenarios, market shocks and other stresses..”
The board’s stress test is one tool to help ensure that large banks can support the economy during downturns. The test assesses the resilience of large banks by estimating their capital levels, losses, revenues and expenses under a single hypothetical recession and financial market shock, using bank data through the end of last year.
All 23 banks tested remained above minimum capital requirements during the hypothetical recession, despite projected total losses of $541 billion. Under pressure, the overall ratio of common equity risk-based capital — which provides protection against losses — is expected to decline by 2.3 percentage points to a minimum of 10.1 percent.
This year’s stress test includes a severe global recession with a 40 percent drop in commercial real estate prices, a huge increase in office vacancies, and a 38 percent drop in housing prices. The unemployment rate rises by 6.4 percentage points to a peak of 10% and economic output falls proportionately.
The focus of the test on commercial real estate shows that while large banks would suffer huge losses in the hypothetical scenario, they would still be able to continue lending. Banks in this year’s test owned nearly 20 percent of the office and downtown commercial mortgages held by banks. The expected significant decline in commercial real estate prices, together with the large increase in office vacancies, contributes to projected loss rates on office property that are three times the levels reached during the 2008 financial crisis.
Projected total losses of $541 billion include more than $100 billion in losses on commercial real estate and residential mortgages, and $120 billion in credit card losses, both higher than expected losses in last year’s test. The overall equity decrease of 2.3 percentage points is slightly less than the 2.7 percentage point decline from last year’s test but comparable to the declines expected from the stress test in recent years. The disclosure document includes additional information on the losses, including results and numbers for the company.
For the first time, the board conducted an exploratory market shock on the trading books of the largest banks, testing them against greater inflationary pressures and rising interest rates. This exploratory market shock will not contribute to the banks’ capital requirements but has been used to further understand the risks of their trading activities and to assess the possibility of testing the banks against multiple scenarios in the future. The results showed that the trading books of the larger banks were resilient in the tested rally environment.
The individual results from the stress test factor directly into the bank’s capital requirements, which dictates that each bank must hold sufficient capital to survive a severe recession and financial market shock. If the bank does not remain above its capital requirements, it is subject to automatic limits on capital distributions and discretionary bonus payments.
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