Fed stress tests see large banks able to handle recession and slide in commercial real estate prices

“The projected decline in commercial real estate prices, combined with
the substantial increase in office vacancies, contributes to projected loss rates on office properties that are roughly triple the levels reached during the 2008 financial crisis,” the Fed said in a prepared statement.

Also read: FDIC studying plan to include smaller U.S. banks in Basel III capital requirements after failures in early 2023

Fed vice chair of supervision Michael S. Barr said the exams confirm that the U.S. banking system remains resilient, even in the wake of the failure of Silicon Valley Bank, Signature Bank and First Republic Bank earlier this year.

Barr also alluded to comments he made last week when he said the Fed should consider a wider range of risks that could derail banks in a process he described as reverse stress tests.

“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,” Barr said in a prepared statement.

The bank stress tests are closely watched because they help determine what capital banks have left over for stock buybacks and dividends. However, expectations are not particularly high at the current time for any huge payouts to investors given talk by regulators about high capital requirements tied to Basel III international banking laws, as well as a challenging economic environment with interest rates on the rise in an attempt to cool economic activity and tame inflation.

Senior Fed officials said banks will be clear to provide updates on their stock buybacks and dividends after the market close on Friday.

For the first time, the Fed conducted an “exploratory market shock” on the trading books of the U.S.’s eight largest banks including greater inflationary pressures and rising interest rates.

The results showed that the largest banks’ trading books were resilient to the rising rate environment tested. That group included Bank of America Corp., the Bank of New York Mellon, Citigroup Inc., the Goldman Sachs Group Inc., JPMorgan Chase & Co. , Morgan Stanley , State Street Corp, and Wells Fargo & Co.

Senior federal officials said they’re studying a wider application of the exploratory market shock to other banks.

In last year’s tests, the Fed did not place an emphasis on a rapid rise in interest rates partly because expectations were high for a recession with lower interest rates in 2023. Instead, interest rates rose. That market dynamic was a factor in the collapse of Silicon Valley Bank, which sold securities with lower interest rates at a loss to cover an increase in withdrawals, only to spark a run on the bank.

All told, the Fed said the 23 banks in the stress test managed to maintain their capital requirements even with a projected $541 billion in losses. (See breakdown below).

Under the most severe stress, the aggregate common equity risk-based capital ratio would decline by 2.3% to a minimum of 10.1%.

Other facets of the hypothetical recession included a “substantial” increase in office vacancies, a 38% reduction in house prices and a 6.4% increase in U.S. unemployment to a high of 10%. The drop in house prices in this year’s stress tests is worse than the decline in the Global Financial Crisis in 2008.

“The results looked pretty good,” said Maclyn Clouse, a professor of finance at the University of Denver’s Daniels College of Business. “The banks were in pretty good shape from a capital standpoint and they’d be able to withstand some shock. It’s good news.”

Barr’s remark on Fed officials being “humble” reflects the fact that regulators largely missed the Global Financial Crisis as well as the sudden demise of Silicon Valley Bank in March.

“They need to be humble,” Clouse said. “We need to be a little more humble about the results and a little more alert about new challenges that normally haven’t been looked at with stress tests.”

This year, the banks that took part in the stress tests including Bank of America Corp.
BAC,
+2.64%,
Bank of New York Mellon Corp.
BK,
+0.79%,
Capitol One Financial Corp.
COF,
-0.93%,
Charles Schwab Corp.
SCHW,
+1.89%,
Citigroup
C,
+0.50%,
Citizens Financial Group Inc.
CFG,
+1.36%
and Goldman Sachs Group Inc.
GS,
+2.36%.

Other exams took place at J.P. Morgan Chase & Co.
JPM,
+2.27%,
M&T Bank Corp.
MTB,
+3.07%,
Morgan Stanley
MS,
+1.87%,
Northern Trust Corp.
NTRS,
+1.04%,
PNC Financial Services Group Inc.
PNC,
+1.18%,
State Street Corp.
STT,
+1.37%,
Truist Financial Corp.
TFC,
+1.20%,
U.S. Bancorp
USB,
+1.74%
and Wells Fargo & Co.
WFC,
+3.05%.

In 2022, the Fed said banks could withstand 10% unemployment and a 55% drop in stock prices as part of the year-ago stress test.

KBW analyst David Konrad said in a June 22 research note he expected no “huge surprises” in addition to capital uncertainty around dividends and buybacks already expected by Wall Street.

Providing guidance on how the Fed will study bank strength, Fed chair of supervision Michael Barr said last week that the Fed needs to consider “reverse stress tests” to look at “different ways an institution can die” instead of simply submitting banks to a specific list of hypothetical hardships.

“We have to work harder at looking at patterns we haven’t seen before,” Barr said at an appearance on June 20.

Also Read: Fed official eyes ‘reverse stress tests’ for banks as results awaited after 2023 bank failures

Also read: FDIC studying plan to include smaller U.S. banks in Basel III capital requirements after failures in early 2023