The Federal Reserve Board released its annual bank stress test results on Wednesday, demonstrating that big banks are well-positioned to weather a severe recession and continue to lend to households and businesses even during a severe downturn.
“Today’s results confirm that the banking system remains strong and resilient,” said Michael S. Barr said. “At the same time, this stress test is only one way to measure that strength. We must remain humble about how risks may arise and continue our work to ensure that banks are resilient to a range of economic conditions, market shocks and other pressures.”
The board’s stress testing is a tool to help ensure that big banks can support the economy during an economic downturn. Using data from banks at the end of the previous year, the test assesses the resilience of large banks by estimating their capital positions, losses, earnings and expenses under a single hypothetical recession and financial market shock.
All 23 banks examined exceeded their minimum capital requirements during the hypothetical recession, despite total losses of $541 billion. Under stress, the total common equity risk-based capital ratio — which provides a cushion against losses — is forecast to decline by 2.3 percentage points to a minimum of 10.1 percent.
This year’s stress test included a severe global recession, a 40 percent drop in commercial real estate prices, a significant increase in office vacancies and a 38 percent drop in home prices. The unemployment rate rises by 6.4 percentage points to a peak of 10 percent and economic output falls accordingly.
The test’s focus on commercial real estate shows that in hypothetical scenarios big banks can continue to lend while they suffer huge losses. Banks held about 20 percent of the office and downtown commercial real estate loans held by banks in this year’s test. A large projected decline in commercial real estate prices, combined with a substantial increase in office vacancies, is contributing to loss rates for office properties that are roughly triple the levels reached during the 2008 financial crisis.
Total projected losses of $541 billion include more than $100 billion in losses from commercial real estate and residential mortgages, and $120 billion in credit card losses, both higher than losses predicted in last year’s test. The total 2.3 percentage point decline in capital is slightly lower than the 2.7 percentage point decline from last year’s test, but comparable to declines predicted from stress tests in recent years. The disclosure document contains additional information about losses, including concrete results and figures.
For the first time, the board conducted an exploratory market shock on the trading books of the biggest banks, testing them against higher inflationary pressures and interest rates. This research market shock does not contribute to banks’ capital requirements, but was used to further understand the risks of their trading activities and to assess banks’ ability to test against multiple scenarios in the future. The results show that the trading books of the largest banks are resilient to the tested rising rate environment.
A bank’s capital requirements derive directly from the stress testing factor, which requires each bank to hold sufficient capital to withstand severe recessions and financial market shocks. If a bank does not exceed its capital requirements, it is subject to automatic restrictions on capital distributions and discretionary bonus payments.
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