The annual regulatory stress test of the biggest banks in the US showed smaller hypothetical losses compared with the year prior, bucking expectations that they would put broad upward pressure on capital standards.
In the aggregate, the banks' common equity Tier 1 (CET1) ratio fell by a maximum of 2.3% in the simulation, compared with a decline of 2.7% in 2022. The aggregate loan loss rate was 6.4%, flat with 2022. The results were published June 28 by the Federal Reserve.
Analysts had expected a worse performance, citing tough macroeconomic and financial parameters used in the exercise and signals from regulators that more capital is needed to support banks' stability. Regulators have said they plan to introduce a raft of proposals to change capital and other regulations over the coming months, with the effort informed by the spectacular deposit runs that led to the collapses of three large banks in March and May.
The annual stress test is designed to assess big banks' ability to keep lending during a severe recession, and all of them stayed well above the minimum CET1 requirement of 4.5% of risk-weighted assets despite the simulated losses.
"Today's results confirm that the banking system remains strong and resilient," Fed Vice Chair for Supervision Michael Barr said in a news release. "At the same time, this stress test is only one way to measure that strength. We should remain humble about how risks can arise and continue our work to ensure that banks are resilient to a range of economic scenarios, market shocks, and other stresses."
Results varied widely among institutions, reflecting factors like relative exposure to loan types that are expected to generate the greatest loss levels, and three were projected to produce positive pretax net income across the nine-quarter stress test horizon beginning at the end of 2022. This year's parameters incorporated large declines in residential real estate prices, concentrated in markets that have experienced large price increases. They also incorporated large declines in commercial real estate prices concentrated in property types, like office buildings, thought to be vulnerable to factors like work-from-home trends.
The Fed said the biggest banks in the stress test — where unrealized losses on bonds impact regulatory capital — were helped by a scenario that called for a decline in interest rates, lifting the value of large holdings of underwater securities. "However, banks with concentrations in mortgages, credit cards, and commercial real estate generally had larger declines in post-stress capital ratios this year," it said.
The Fed said the loss rates on office loans estimated in the test were about triple the levels reached during the 2008 financial crisis.
The stress test also determines stress capital buffers (SCBs), capital cushions that large banks are required to hold in addition to the 4.5% minimum. SCBs mostly reflect simulated losses at individual banks and are subject to a minimum of 2.5%. The banks are free to pay dividends and repurchase stock as long as they remain above their SCBs.
The decline in starting CET1 to minimum simulated CET1 under the test was smaller than last year at 14 of the 23 banks that participated.
Among those with worse outcomes compared to last year was U.S. Bancorp whose starting-to-minimum CET1 ratio deterioration was 1.8 percentage points, up from 0.7 percentage point in 2022. At Capital One Financial Corp. it was 4.5 percentage points, up from 2.9 percentage points in 2022. At Truist Financial Corp., it was 2.3 percentage points, up from 1.8 percentage points.
Banks with $100 billion or more of assets are subject to the stress test, though banks with $100 billion to $250 billion of assets are generally required to participate only every other year currently. Citizens Financial Group Inc. and M&T Bank Corp. were both also required to participate this year because of recent acquisitions of, respectively, Investors Bancorp Inc. and People's United Financial Inc. Some analysts expect all the large banks to be subject to the stress test annually in the future as a part of rule changes that could emerge after the bank failures this year.
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This year's stress test also included an "exploratory market shock component" for the eight largest and most systemically important US banks that will not be used to determine SCBs. The exploratory shock encompassed a less severe recession and higher inflation designed to probe for potential weaknesses in bank's portfolios. Rapid interest rate hikes by the Fed to fight high inflation have damaged the value of banks' assets and were a component of the failures this year.
Losses estimated under the exploratory shock were lower than those estimated under the "global market shock" used in the core test for almost all of the banks. At Wells Fargo & Co., losses estimated under the exploratory shock were $12.4 billion, higher than the losses of $12.2 billion estimated under the global market shock.
The Fed said the "results showed that the largest banks' trading books were resilient to the rising rate environment tested."