The financial crisis has left both the federal government and US banks fearing a recurring economic storm, where unemployment would skyrocket, house prices would take a deep dive and Wall Street would crash. Yet even in the gloomiest of scenarios, Federal Reserve stress tests suggest that US banks could withstand nightmarish economic storms.
Wall Street reluctantly awaited the results of these stress tests, which were made public on Thursday. These annually occurring, Dodd Frank Act-mandated investigations hope to accurately assess whether a recession or a deep market shock would disturb US markets.
Essentially, the Federal Reserve evaluates the total losses that banks could suffer during a theoretical storm and cross-references it with the bank’s capital and the extent to which this capital were to be depleted by the bank’s losses.
The results are in and over 31 of the largest US banks had sufficient capital, the Reserve said, to efficiently absorb massive losses even in the case of an economic breakdown. Satisfyingly, it’s the first time since the stress tests became mandatory, that none of the investigated firms fell below the main capital threshold.
“Higher capital levels at large banks increase the resiliency of our financial system,”
Federal Reserve governor, K. Tarullo said, underlining the importance of these stress tests in ensuring that US banks have sufficient capital to continue lending even in the case of economic downturns. And while some banks performed worse than others (Goldman Sachs, for instance, was particularly close to not meeting the minimum requirement for one measure of capital), the overall results were good.
The Fed’s latest stress test involved the following scenario: during a deep recession, unemployment rates would skyrocket to 10 percent, house prices would lose 25% of their value, the stock market would fall by 50% and the 31 banks involved in the test would suffer losses amounting to $490 billion over two years. And while the current results seem fairly refreshing, they are only the first stage of the Fed’s test.
Next Wednesday marks an even more important moment, as banks will find out whether their shareholder capital distribution plans were approved. In the case of banks falling short or close to the minimum capital levels, these shareholder capital distributions might have to be scaled back.
“This week’s tests are a more modest standard than what we will get next week. […]We will see a few banks fail next week.”
Moody’s Analytics senior director, Cayetano Carrasco-Gea noted.
JPMorgan Chase & Co., Citigroup Inc., Wells Fargo and Co. and the Bank of America Corp. were only a few of the banks included in the stress tests. According to stress test results, JP Morgan Chase, Citigroup and Morgan Stanley did fall below 5 percent for “leverage ratio” (a measure of capital), however, they all remained above the 4 percent minimum requirement. But on Wednesday, an important question will be answered: do any of these banks fall under the minimum requirement because of their planned capital payouts?
Thursday’s announcement allows such banks to now reassess their capital payout proposals, their stock buy-backs and their dividend payments in order to ensure they remain well above the minimum requirements set by the Fed.