Banking crisis in 2007/2009 and the expected bankruptcy of many big- banks in various countries due to housing, and other monetary / financial issues naturally attracted the attention of the concerned governments. The central bank of U.S.A., namely, the Federal Reserve, established in 1913 and being the torch bearer of the monetary moves of the central banks of the world, started the capital stress tests which played an important role in bolstering confidence in the capital positions of U.S. banks. This became an important supervisory tool too.
The Federal Reserve conducts stress tests to ensure that large banks are sufficiently capitalized and able to lend to households and businesses even in a severe recession. The stress tests evaluate the financial resilience of banks by estimating losses, revenues, expenses, and resulting capital levels under hypothetical economic conditions. The recent pandemic was a recent example.
Let me elaborate the situation in simple terms.
The Federal Reserve develops stress test scenarios; It develops or selects the stress test model: The banks submit the data.
Then what?
Using the scenario data and bank data as variables in the stress test models, the Federal Reserve projects how the banks are likely to perform under the hypothetical economic conditions. All artificially projected, no doubt.
The Federal Reserve uses the results of the supervisory stress test, in part, to inform capital requirements for participating banks.
Let me elaborate a little more of stress tests.
Starting in 2013. The Federal Reserve’s capital assessment of the large banks consisted of two primary components: the Dodd-Frank Act stress tests (popularly known as stress test) and the other, the Comprehensive Capital Analysis and Review (CCAR).
What is a stress test process?
The Federal Reserve projects these stress test results using a set of supervisory models that use bank-provided data on their financial conditions and risk characteristics, as well as the Federal Reserve’s scenarios.
The stress test uses models developed or selected by the Federal Reserve, which may be refined each year in advance of the stress test, and these models use bank-provided data collected primarily through regulatory reporting.
This year, the supervisory severely adverse scenario is characterized by a severe global recession accompanied by a period of heightened stress in commercial and residential real estate markets, as well as in corporate debt markets.
This indicates that a severe global recession is presumed to happen along with a period of hyper active stress in commercial real estate markets/corporate debt markets.
USA annual bank stress test showed that while large banks would endure greater losses than last year’s test, they are well positioned to weather a severe recession and stay above minimum capital requirements in its communication dated June 26, 2024. Also, it discussed about the details of the stress tests conducted and other relevant details in its report titled “2024 Federal Reserve Stress Results”.
Now the details of the study undertaken by the Federal Reserve and more results from the same.
Which were the banks asked to submit the data?
U.S. global systemically important bank holding companies (Category I)
U.S. intermediate holding companies of foreign banks with $700 billion or more in total assets or $75 billion or more in cross-jurisdictional activity (Category II)
Domestic bank holding companies and U.S. intermediate holding companies of foreign banks with $250 billion or more in total assets or $75 billion or more in weighted short-term wholesale funding, nonbank assets, or off-balance-sheet exposure (Category III)
Category based on submission of data every two years (in year, ending in even.)
Domestic bank holding companies and U.S. intermediate holding companies of foreign banks with $100 billion or more in total assets that do not meet the requirements for every-year stress testing (Category IV)
Note: Bank holding companies of this asset size may also elect to participate in a stress test in a year ending in an odd number.
A list of 31 Banks participated in the stress test. The results of the stress test are given in the report as under.
https://www.federalreserve.gov/publications/files/2024-dfast-results-20240626.pdf
Brief details of the reports, chapter- wise.
1.0 Preface
2.0 Executive summary
3.0 Background
Stress test process
Participating banks
4.0 Results for banks under the severely adverse scenario
5.0 Appendix A – Additional bank specific results
6.0 Disclosure loan category definitions
Let us learn the important results from the above report and its recommendations.
A list of 31 banks participated under 4 categories for the tests.
I want to give the names of some Category1 banks as under. They are the largest, of course.
Bank of America, Bank of NY-Mellon, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan Stanley, State Street, and Wells Fargo.
The 2024 stress test shows that the 31 large banks subject to the test this year have sufficient capital to absorb nearly $685 billion in losses and continue lending to households and businesses under stressful conditions.
The break up of $684 billion is as under:
$571 billion in loan losses, accounting for 83 percent of total losses;
$16 billion in additional losses from items such as loans booked under the fair-value option accounting for 2 percent of total losses;
$91 billion in trading and counterparty losses at the 10 banks with substantial trading, processing, or custodial operations, accounting for 13 percent of total losses;
$6 billion in securities losses, accounting for 1 percent of total losses.
It is equally heartening to know that in the immediate years after the 2007–09 Global Financial Crisis, banks subject to the stress test substantially increased their capital, which has remained largely level for the past few years.
The Federal Reserve’s evaluation of a bank’s common equity capital was initially measured using a tier 1 common capital ratio but now is evaluated using a common equity tier 1 capital ratio. Not all of the banks included in the 2024 stress test reported data for all periods since 2009.
Results for Banks under the Severely Adverse Scenario
Under the severely adverse scenario, the aggregate common equity tier 1 (CET1) capital ratio of the 31 banks subject to the stress test this year falls from an actual 12.7 percent (Q4- 2023) to its projected minimum of 9.9 percent, before rising to 10.4 percent (projected 2026 Q1)
What Is Common Equity Tier 1 (CET1)?
Common Equity Tier 1 (CET1) is a component of Tier 1 capital and comprises primarily of common stock held by a bank or other financial institution. ET1 is a capital measure that was introduced in 2014 as a precautionary way to protect the economy from a financial crisis. Category 1 Banks are expected to meet the minimum CET1 ratio requirements to their risk-weighted assets (RWAs) as outlined by their financial regulators.
From page 10 of the report the following information about category 1 banks in respect of Projected minimum common equity tier 1 capital ratio under the severely adverse scenario, 2024: Q1–2026: Q1 for 31 banks, I have given below the details for category 1 banks only.
| Name | Stressed ratios with supervisory stress testing capital action assumptions In % |
| Bank of America |
9.1 |
| Bank of NY- Mellon |
12.2 |
| Citigroup |
9.7 |
| Goldman Sachs |
8.5 |
| J P Morgan Chase |
12.5 |
| Morgan Stanley |
10.6 |
Keeping in mind the changing economic and consequent results on the working of banks, the Federal Reserve kept the following factors into consideration while finalising its supervisory stress tests for 2024 calling them as model adjustments. From page 14 of the report.
- It assumes that losses associated with certain loans backed by U.S. government agency guarantees will not be absorbed by banks in the stress test. Consistent with this practice, the Federal Reserve applied an adjustment to the applicable loan loss models to factor in shared-loss agreements with the Federal Deposit Insurance Corporation (FDIC).
- On November 16, 2023, the FDIC approved a final rule implementing a special assessment to recover the loss to the Deposit Insurance Fund associated with the closures of Silicon Valley Bank and Signature Bank. As these expenses are expected to be one-time events, the Federal Reserve excluded expenses related to this special assessment when producing stressed expense projections.
- The interest rate environment revealed differences in banks’ reporting of some interest expenses. Some banks report these interest expenses in the “all other” category, while others report the same type of interest expense as “trading liabilities and other borrowed money. Federal reserve made the required adjustments for these two categories.
- Variable compensation for its human resources of the banks have resulted in uneven calculation of compensation expenses for the banks. This was looked at by Fed Reserve.
- The debt service coverage ratio is the ratio of commercial real estate (CRE) property’s net operating income to its debt payments. The failure of some payments under this category affected the net operating income from these debts. This was one among others under the stress test calculations.
- Synthetic securitizations are a form of loss mitigation in which a bank partially transfers credit risk on specific portfolios to outside investors through credit derivatives or guarantees. The Federal Reserve incorporated a richer dataset and considered this type of credit protection in modelling fair-value-option/held-for sale loan losses.
Let me also give the working figures of one of the banks as assessed by the Fed Reserve under the stress test scenario.
From page 34 of the report,
Table A.3. Bank of America Corporation Projected stressed capital ratios, loan losses, risk-weighted assets, losses, revenues, and net income before taxes Federal Reserve estimates: Severely adverse scenario.
Capital ratios and risk-weighted assets, actual 2023: Q4 and projected 2024: Q1–2026: Q1 Percent except as noted. All amounts in US $.
| Item | Actual 2023 Q4 | Projected 2026 Q1 |
| Common equity tier 1 capital ratio % | 11.8 | 9.3 |
| Risk weighted assets (billions $) | 1651 | 1634 |
Projected loan losses, by type of loan, 2024: Q1–2026: Q1
| Loan type | Billions in $ | % |
| Loan losses | 60.4 | 5.5 |
| Commercial and industrial | 18.6 | 5.9 |
| Commercial real estate, domestic | 8.9 | 11.4 |
| Credit cards | 17.0 | 16.7 |
Conclusion
Large bank exposure to commercial real estate (CRE) debt remains an area of focus for Federal Reserve supervisors. The 2024 supervisory severely adverse scenario features heightened stress in CRE, including a 40 percent decline in CRE prices. The projected CRE loss rate in the 2024 stress test is the same as the projected loss rate in the 2023 stress test (8.8 percent), and as such, projected CRE losses, while significant at $77 billion, are not a notable driver of year-over-year changes in the stress test results.
However, the large banks are adequately capitalized to absorb losses, if any.
Caution
Totally enjoying the study of Federal Reserve on stress tests on banks, the above article was written to be shared among us. Please consult a monetary expert to apply the principles enunciated therein. RBI has evolved its own standards for Indian banks.