Fed Releases Summary Results of Bank Stress Tests
According to the summary results of bank stress tests announced by the Federal Reserve on Thursday, the largest banking institutions in the United States are collectively better positioned to continue to lend to households and businesses and to meet their financial commitments in an extremely severe economic downturn than they were five years ago. This result reflects continued broad improvement in their capital positions since the financial crisis.
Reflecting the severity of the most extreme stress scenario—which features a deep recession with a sharp rise in the unemployment rate, a drop in equity prices of nearly 50 percent, and a decline in house prices to levels last seen in 2001—projected loan losses at the 30 bank holding companies in the latest stress tests would total $366 billion during the nine quarters of the hypothetical stress scenario. The aggregate tier 1 common capital ratio, which compares high-quality capital to risk-weighted assets, would fall from an actual 11.5 percent in the third quarter of 2013 to the minimum level of 7.6 percent in the hypothetical stress scenario. That minimum post-stress number is significantly higher than the 30 firms' actual tier 1 common ratio of 5.5 percent measured in the beginning of 2009.
Capital is important to banking organizations, the financial system, and the economy broadly because it acts as a cushion to absorb losses and helps to ensure that losses are borne by shareholders, not taxpayers. The Federal Reserve's stress scenario estimates are the outcome of deliberately stringent and conservative assessments under hypothetical economic and financial market conditions and the results are not forecasts or expected outcomes.
"The annual stress test is one of the Federal Reserve's most important tools to gauge the resiliency of the financial sector and to help ensure that the largest firms have strong capital positions," Federal Reserve Governor Daniel K. Tarullo said. "Each year we are making substantial improvements, which have helped make the process even stronger than when we first conducted the stress tests in the midst of the financial crisis five years ago."
This is the fourth round of stress tests led by the Federal Reserve since the tests in 2009 and is the second year that the Federal Reserve has conducted stress tests pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act. The changes to the tests this year are as follows:
- In addition to the 18 institutions that have been part of the stress tests since 2009, an additional 12 firms with assets greater than $50 billion were included this year;
- The Federal Reserve used independent projections of balance sheet and risk-weighted asset growth rather than depending on the firms' calculation for these categories as was done in prior years, improving the comparability and robustness of the results;
- The tests included an estimate of losses that could result if a financial institution's largest counterparty were to default unexpectedly. This scenario was applied to eight firms with substantial trading or custodial operations. The counterparty default scenario is part of the global trading shock, which is applied to six firms with large trading operations; and
- The Federal Reserve in this year's test began to phase in the revised capital framework approved by the Board in July 2013. The Federal Reserve calculated each firm's capital ratios in accordance with the capital requirements that will be in effect during each projected quarter.
In addition to releasing results under the severely adverse hypothetical scenario, the Federal Reserve also on Thursday released results from the adverse scenario, which features a more moderate recession than that seen in the severely adverse scenario, but includes a steep rise in long-term interest rates. In the adverse scenario, the aggregate tier 1 common capital ratio would fall from an actual 11.5 percent in the third quarter of 2013 to the minimum level of 9.7 percent in the hypothetical stress scenario.
The quantitative results from both the adverse and the severely adverse scenarios in the supervisory stress tests are only one component in the Federal Reserve's analysis during the Comprehensive Capital Analysis and Review (CCAR). CCAR is an annual exercise in which the Federal Reserve evaluates the capital planning processes and capital adequacy at the largest financial institutions. The latest CCAR results will be released on Wednesday, March 26, at 4 p.m. EDT. It is important to note that capital plans of firms in CCAR have been objected to on qualitative grounds even when capital ratios have exceeded all minimum post-stress capital requirements.
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