Fed stress test reveals big banks can weather severe recession

The Fed gave the largest US banks a clean bill of health in its annual stress test, saying they would be able to continue lending to households and businesses even in a severe recession.

This year’s stress test measures the ability of the 34 largest banks to maintain strong capital levels in a hypothetical recession characterized by a sharp rise in unemployment and a sharp decline in stock prices.

The Fed said that banks under test remained above minimum capital requirements in the worst-case test scenario, even though they would collectively lose more than $600 billion.

Their capital ratios will drop to 9.7%, more than double their minimum requirements, according to the Federal Reserve. The larger banks have additional fees that require them to maintain higher levels of capital beyond the minimum.

The severely opposite scenario, as it is known, was the unemployment rate in the United States rising to a peak of 10% in the third quarter of next year. It assumed a 40% fall in commercial real estate prices, a 28.5% fall in home prices, widening corporate bond spreads, a 55% decline in stock prices and increased market volatility.

The Fed said this year’s hypothetical scenario is tougher than the 2021 test by design. Last year’s test found that the 23 largest US banks would collectively lose more than $470 billion. Some smaller banks are only required to take the test every two years.

This year, the country’s largest banks, including JPMorgan Chase & Co. and Bank of America corp.

Its capital levels experienced a larger decline than last year due to higher loans and trading losses.

The rapid and robust economic recovery from the pandemic has helped major banks post record profits in recent years. However, recession fears cloud their outlook. Inflation is at a 40-year high, and Federal Reserve Chairman Jerome Powell said this week that higher interest rates in response to higher prices could push the economy into recession. Several bank executives have issued similar warnings in recent weeks.

How banks perform on tests determines how much capital they have to stay away from due to potential problems. Once this requirement is met, they can return their excess capital to shareholders in buybacks and dividends. Banks are expected to announce their capital plans on Monday evening.

Barclays analysts said in a research note that major US banks will likely boost their dividends soon, but total share buybacks are expected to fall to $13 billion in the second quarter from $36 billion last summer and remain sluggish.

The Federal Reserve temporarily banned share buybacks and restricted dividend payments in 2020, citing the need to preserve capital during the spread of the coronavirus pandemic. These restrictions were removed last summer.

Stress tests were introduced in the aftermath of the 2008-2009 financial crisis, when the US government bailed out some of the largest financial institutions. The results of the first tests helped restore investor confidence in the banking system.

Bank stocks have fallen this year after a sharp rally in 2021. The KBW Nasdaq Bank is down 24% so far in 2022, a slightly worse performance than the S&P 500.

write to Charlie Grant at charles.grant@wsj.com and David Benoit at david.benoit@wsj.com

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It appeared in the June 24, 2022, print edition as “Banks Get Strong Scores on Financial Stress Tests”.

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