Explainer – What is the Fed’s bank ‘stress test’ and what’s new this year? By Reuters

Nusarina Buchori June 24, 2024

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Explainer – What is the Fed’s bank ‘stress test’ and what’s new this year? By Reuters

By Pete Schroeder and Michelle Price

WASHINGTON (Reuters) – The US Federal Reserve is expected to release the results of its annual banking health examination on Wednesday at 4:30 pm ET (2030 GMT). Under the “stress test”, the Fed evaluates the balance sheets of major banks against the hypothetical scenario of a major recession, the characteristics of which change every year.

The results indicate how much money these banks need to be considered healthy and how much they can return to shareholders through share buybacks and dividends. This year, America’s biggest lenders are expected to show again that they have enough money to deal with any new turmoil in the banking sector.

WHY IS THE FED ‘STRESS TESTING’ BANKS?

The Fed established the tests following the 2007-2009 financial crisis as a tool to ensure that banks can withstand similar shocks in the future. The tests officially began in 2011, and the big lenders initially struggled to get passing grades.

Citigroup, Bank of America, JPMorgan Chase & Co, and Goldman Sachs Group (NYSE: ), for example, had to adjust their capital plans to address the Fed’s concerns. Deutsche Bank’s US subsidiary failed in 2015, 2016 and 2018.

However, years of practice have made banks more experienced in the tests and the Fed has also made the tests more transparent. It ended the high drama of the experiment by scrapping the “failure” model in 2020 and introducing a bank-specific currency regime.

HOW ARE BANKS ASSESSED NOW?

The test assesses whether banks will stay above the minimum 4.5% required capital ratio – which represents a percentage of their capital relative to assets – during a recession. The most efficient banks usually stay above that. The country’s central banks must also withhold a “G-SIB surcharge” of at least 1%.

How well a bank does in the test also determines the size of the “stress currency wound,” the additional portion of money introduced in 2020 that sits above the 4.5% minimum rate.

That additional cushion is determined by the assumed losses of each bank. The bigger the loss, the bigger the buffer.

ROLL OUT

The Fed will release results after markets close. It usually publishes aggregate industry losses, as well as individual bank losses that include details of how specific portfolios – such as credit cards or loans – performed.

The central bank usually does not allow banks to announce their dividend plans and buybacks a few days after the results. It announces the size of each bank’s stress capital buffer for the following months.

The performance of the country’s largest lenders, notably JPMorgan, Citigroup, Wells Fargo & Co, Bank of America, Goldman Sachs, and Morgan Stanley, are closely watched by the markets.

TRIAL FOR 2023

The Fed changes conditions each year. They took months to compile and review the summary of the banks’ balance sheets at the end of last year. That means they are in danger of becoming obsolete.

In 2020, for example, the real economic downturn caused by the COVID-19 pandemic was many measures more severe than the Fed’s stance that year.

After the failure of mid-sized lender Silicon Valley Bank, Signature Bank (OTC:) and First Republic last year, the Fed was criticized for not testing bank balance sheets against rising interest rates, and instead assumed rates would fall during the Great Recession.

This year’s assessment is broadly in line with the 2023 assessment, with the projected unemployment rate under the “very worst” scenario rising to 6.3 percent compared to 6.4 last year.

WARRANTIES IN COMMERCIAL REAL ESTATE

The assessment also looked at the 40% drop in real estate prices, which has been a concern over the past two years as office vacancies during the pandemic and higher for long-term interest rate borrowers.

In addition, banks with large trading activities will be tested against “global market shocks,” and others will be tested against the failure of their largest company.

Second, the Fed is also conducting “test” shocks to banks. This year’s test also includes additional economic and market test shocks that will not help set monetary requirements, but will help the Fed gauge whether it should increase the test in the future. Market shocks will apply to central banks, and all 32 will be tested for economic shocks.

Federal Reserve Board Vice Chairman Michael Barr said many conditions would make inspections better at detecting banks’ weaknesses.

WHERE ARE THE EXAMINATION BANKS?

By 2024, 32 banks will be audited. That rose to 23 last year, as the Fed decided in 2019 to allow banks with assets between $100 billion and $250 billion to be audited annually.

These are the banks being tested in 2024:

Ally Financial (NYSE: )

American Express (NYSE:)

Bank of America Corporation (NYSE: )

The Bank of New York Mellon (NYSE:) Corporation

Barclays US LLC

BMO Financial Corp.

Capital One Financial Corporation (NYSE: )

I Charles Schwab Corporation (NYSE:)

Citigroup

Citizens Financial (NYSE:) Group, Inc.

Credit Suisse Holdings (USA)