The U.S. Federal Reserve is due to release the results of its annual bank health checks on Wednesday at 4:30 p.m. ET (2030 GMT). Under the “stress test” exercise, the Fed tests big banks’ balance sheets against a hypothetical scenario of a severe economic downturn, the elements of which change annually.
The results dictate how much capital those banks need to be deemed healthy and how much they can return to shareholders via share buybacks and dividends. This year, big U.S. lenders are once again expected to show they have ample capital to weather any fresh turmoil in the banking sector.
Why does the Fed ‘stress test’ banks?
The Fed established the tests following the 2007-2009 financial crisis as a tool to ensure banks could withstand a similar shock in future. The tests formally began in 2011, and large lenders initially struggled to earn passing grades.
Citigroup, Bank of America, JPMorgan Chase & Co, and Goldman Sachs Group, for example, had to adjust their capital plans to address the Fed’s concerns. Deutsche Bank’s U.S. subsidiary failed in 2015, 2016 and 2018.
However, years of practice have made banks more adept at the tests and the Fed also has made the tests more transparent. It ended much of the drama of the tests by scrapping the “pass-fail” model in 2020 and introducing a more nuanced, bank-specific capital regime.
How are banks assessed now?
The test assesses whether banks would stay above the required 4.5 per cent minimum capital ratio – which represents the percentage of its capital relative to assets – during the hypothetical downturn. Banks that perform strongly typically stay well above that. The nation’s largest global banks also must hold an additional “G-SIB surcharge” of at least 1 per cent.
How well a bank performs on the test also dictates the size of its “stress capital buffer,” an additional layer of capital introduced in 2020 which sits on top of the 4.5 per cent minimum.
That extra cushion is determined by each bank’s hypothetical losses. The larger the losses, the larger the buffer.
The roll out
The Fed will release the results after markets close. It typically publishes aggregate industry losses, and individual bank losses including details on how specific portfolios – like credit cards or mortgages – fared.
The central bank typically does not allow banks to announce their plans for dividends and buybacks until a few days after the results. It announces the size of each bank’s stress capital buffer in the subsequent months.
The performance of the country’s largest lenders, particularly JPMorgan, Citigroup, Wells Fargo & Co, Bank of America, Goldman Sachs, and Morgan Stanley, are closely watched by the markets.
Test in line with 2023
The Fed changes the scenarios each year. They take months to devise and test a snapshot of banks’ balance sheets at the end of the previous year. That means they risk becoming outdated.
In 2020, for example, the real economic crash caused by the COVID-19 pandemic was by many measures more severe than the Fed’s scenario that year.
After the failures of mid-size lenders Silicon Valley Bank, Signature Bank and First Republic last year, the Fed was criticized for not having tested bank balance sheets against a rising interest rate environment, and instead assuming rates would fall amid a severe recession.
This year’s test is broadly in line with the 2023 test, with the hypothetical unemployment rate under a “severely adverse” scenario rising 6.3 percentage points compared with 6.4 last year.
Stresses in commercial real estate
The exam also envisages a 40 per cent slump in the prices of commercial real estate, an area of concern over the past two years as lingering pandemic-era office vacancies and higher for longer interest rates stress borrowers.
In addition, banks with large trading operations will be tested against a “global market shock,” and some will also be tested against the failure of their largest counterparty.
For the second time, the Fed is also conducting “exploratory” shocks to banks. This year’s test also includes additional exploratory economic and market shocks which won’t help set capital requirements, but will help the Fed gauge whether it should broaden the test in the future. The market shocks will apply to the largest banks, while all 32 will be tested on the economic shocks.
Fed Vice Chair for Supervision Michael Barr has said multiple scenarios could make the tests better at detecting banks’ weaknesses.
Which banks are tested?
In 2024, 32 banks will be tested. That’s up from 23 last year, as the Fed decided in 2019 to allow banks with between $100-billion and $250-billion in assets to be tested every other year.