Banks may lose over half a trillion dollars during the next crisis, but that’s no problem according to stress test results released by the Federal Reserve on Thursday evening. The Fed’s annual stress tests gave a clean bill of health to the 33 U.S. lenders with assets over $50 billion that are subject to its review.
Tests this year found that under a “severely adverse” economic environment — think 10% unemployment, negative interest rates, a 50% drop in the stock market, and 25% declines to home prices — these 33 lenders would lose a total of $526 billion, with $385 billion of that figure coming from loan losses, $113 billion coming from trading losses, and an additional $28 billion from various accounting losses.
While the losses would be staggering, the Fed found they would not undermine the stability of any individual banking institution, something that might create a run on the bank reminiscent of the failures of firms such as Lehman Brothers, Bear Stearns and Washington Mutual. The Fed found that across the banks it tested average common equity tier 1 capital would fall from 12.3% to 8.4% in the event of a crisis, and no firm’s capital would fall below 5%, keeping every lender in a position of stability.
How come banks can survive a crisis, versus the 2008 economic collapse, when they all accepted government bailout money? Since 2009, banks subject to the Fed’s stress test have added over $700 billion common equity capital, after selling stock in the wake of the crisis and retaining a vast majority of their profits in recent years.
“The changes we make in each year’s stress scenarios allow supervisors, investors, and the public to assess the resiliency of the banking firms in different adverse economic circumstances,” Daniel K. Tarullo, a governor at the Federal Reserve, said in a statement. “This feature is key to a sound stress testing regime, since the nature of possible future stress episodes is inherently uncertain,” Tarullo added.
Next week, the Fed will reveal whether or not it has approved each of these banks’ 2016 capital plans, potentially allowing them to announce rising dividends or share buybacks.
Among banks tested, Huntington Bancshares HBAN +2.50%, BMO Financial, Ally Financial , Keycorp and Zions Bancorporation were seen by the Fed as having the lowest common equity tier 1 capital levels in a crisis. Huntington was forecast at CETI ratio of 5% at the low end.
Among the biggest six banks in the U.S., both Morgan Stanley MS +3.41% and Citigroup C +4.17% reported 9.1% CETI ratios in a severely adverse scenario, while Goldman Sachs, JPMorgan Chase JPM +2.14% and Bank of America BAC +3.16% were between CETI ratios of 8.1% and 8.3%. Wells Fargo WFC +2.00% came in at the low end with a CETI ratio of 7.2%. In terms of leverage, Morgan Stanley came in at the low end of tests with a leverage ratio of 4.9%, while Citigroup came in at the high end at 6.9%.
“The nation’s largest bank holding companies continue to build their capital levels and improve their credit quality, strengthening their ability to lend to households and businesses during a severe recession,” the Fed said. Added Anna Krayn, senior director at Moody’s Analytics, “today’s DFAST results show that capital levels in the industry are high enough to withstand even a very severe scenario of negative interest rates.
This is the sixth round of stress tests led by the Fed since 2009 and the fourth round required by the Dodd-Frank Act. The 33 firms tested represent more than 80 percent of domestic banking assets. Still, coming CCAR tests may further differentiate between banks and could prove a higher bar to clear.
“Meeting the quantitative benchmark is just the first step. We are expecting to see greater divergence in next week’s results, once the focus turns to qualitative aspects and proposed capital distributions,” said Krayn, of Moody’s.
The question remains whether banks truly can withstand a new crisis. Some are skeptical and expect the Fed to continue adding teeth to its annual tests.
“Have we raised capital requirements substantially since the crisis? Yes,” Kim Schoenholtz, a professor at New York University’s Stern School of Business. “Have we raised sufficiently to make the financial system safe? The answer is no,” he adds.