Losses projected under this year's Federal Reserve stress tests of large banks increased compared with last year, putting upward pressure on capital requirements and creating another headwind for shareholder payouts.
The Fed conducts the stress tests annually to help ensure that big banks have the capacity to keep lending during a severe recession and published the most recent results late on June 23. The size of hypothetical losses estimated for each bank is also used to determine stress capital buffers, or SCBs, one of the elements of banks' capital requirements.
For 33 of the 34 banks in this year's exercise, the aggregate common equity Tier 1, or CET1, ratio fell 2.7 percentage points to a minimum of 9.7% under a "severely adverse" scenario. The aggregate decline last year was 2.4 percentage points to 10.6%.
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Banks with $100 billion to $250 billion in assets are usually subject to the stress tests every other year, and 23 banks participated in 2021. This year, Mitsubishi UFJ Financial Group Inc. unit MUFG Americas Holdings Corp. participated in the stress test, but the Fed said it did not publish results for MUFG because of accounting reclassifications due to a pending divestiture. MUFG has agreed to sell much of its U.S. operation to U.S. Bancorp. The Fed said it had concluded that "MUFG Americas has sufficient capital to absorb losses and continue to serve as a credit intermediary under a severe recession."
Despite the bigger decline in capital this year, all the banks stayed above their minimum capital requirements across the stress test horizon, and the Fed said the exercise "showed that banks continue to have strong capital levels."
Variables used in the tests included substantial stress in commercial real estate and corporate debt markets, and the Fed said this year was "tougher than the 2021 test, by design." The Fed follows a framework that calls for a sharper deterioration when actual conditions are stronger. Aggregate declines in CET1 capital ratios have ranged from 2.1 percentage points to 3.6 percentage points in stress tests since 2018.
The worse performance this year compared with 2021 also reflected lower bank loan loss reserves going into the tests after reversals of early pandemic buildups. In 2021, estimated loan losses were $353.0 billion in the aggregate, considerably larger than the $294.2 billion in hypothetical loss provisions used to determine capital deterioration. This year, estimated loan losses were $463.3 billion in the aggregate, compared with $460.8 billion in hypothetical loss provisions.
The aggregate loan portfolio loss rate this year was 6.4%, compared with 6.2% in 2021.
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For JPMorgan Chase & Co., the differential between starting and minimum CET1 was 3.3 percentage points, compared with 2.4 percentage points last year. For Wells Fargo & Co., it was 2.8 percentage points, flat compared to last year. Both banks had warned that their SCBs could go up.
Overall, 15 of the 23 banks in last year's test showed a larger deterioration in capital this year.
Banks are allowed to pay dividends and repurchase shares without restriction as long as they do not eat into their SCBs. The Fed said it expects banks to wait until after markets close on June 27 to make any announcements about their SCB requirements and capital plans.