By Valerie Hernandez, International Banker
In the United States, the Federal Reserve (the Fed) announced on June 26 that the 31 banks included in this year’s stress test would be able to absorb losses under a severe-recession scenario whilst still maintaining their ability to lend to consumers and corporations. While the results have helped to illuminate the resilience of the US banking sector, a 2.8-percent decline in the banks’ aggregate capital suggests that not-insignificant risks to lenders persist in 2024. And with some banks challenging the Fed on its testing methodology, it increasingly appears that the purported opacity of the stress test itself may well fall under further scrutiny going forward.
According to the Fed, its annual stress test assesses whether banks are sufficiently capitalised to absorb losses during stressful conditions whilst meeting their outstanding obligations to creditors and counterparties, as well as continuing to lend to households and businesses. It does this by assessing banks’ financial resilience through its estimates of their losses, revenues, expenses and resulting capital levels under hypothetical economic conditions. The Fed then uses the results of the stress test to determine the stress capital buffer (SCB) requirement, which integrates the stress test with non-stress capital requirements into one forward-looking and risk-sensitive framework.
As per the latest stress test, it appears that the substantial increase in the banks’ capital following the 2007–09 Global Financial Crisis (GFC) that regulators mandated has proven effective. Indeed, the 2024 results revealed that the 31 large banks involved in this year’s test were deemed to have sufficient capital to absorb nearly $685 billion in losses whilst being able to continue lending to households and businesses under stressful conditions. The 31 banks included in the tests were classified into four risk categories:
- Category I: Bank of America (BofA), Bank of New York Mellon (BNY Mellon), Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street and Wells Fargo,
- Category II: Northern Trust,
- Category III: Barclays US, BMO Financial (Bank of Montreal Financial), Capital One, Charles Schwab, Deutsche Bank USA, PNC Financial Services, TD Bank Group (Toronto-Dominion Bank Group), Truist Financial, UBS United States of America, U.S. Bancorp,
- Category IV: Ally Financial, American Express, Citizens Financial Group, Discover Financial Services, Fifth Third Bank, HSBC, Huntington Bancshares, KeyCorp, M&T Bank, RBC USA (Royal Bank of Canada USA), Regions Bank and Santander US.
Under the Fed’s “severely adverse” scenario that hypothesised a sizeable jump in the US unemployment rate and a collapse in commercial real-estate (CRE) prices, moreover, the banks’ aggregate common equity tier 1 (CET1) capital ratio fell by 2.8 percent from 12.7 percent in the fourth quarter of 2023 to a projected minimum of 9.9 percent. This was a larger decline than the 2.5 percent recorded in 2023’s stress test and the largest since 2018’s 3.6-percent fall. The Fed highlighted three main issues as key factors underpinning this year’s capital decline:
- The substantial increases in banks’ credit-card balances, with banks subject to the stress test growing their credit-card balances by more than $100 billion. Credit-card delinquency rates have also ballooned by 40 percent to inflate losses further. As such, banks will lose an estimated $175 billion on credit cards, or 17.6 percent of credit-card loan balances, in the stress test.
- Banks’ corporate-credit portfolios have become riskier, as reflected by the downgrades of loans by the issuing banks themselves, thus generating higher projected corporate losses. This has meant that the commercial and industrial loss rate rose from 6.7 percent in the 2023 stress test to 8.1 percent in the 2024 stress test.
- The recent decline in non-interest net revenue at banks—such as lower investment-banking fees and higher compensation and real-estate fees—has resulted in lower projected pre-provision net revenues to offset losses from loan portfolios.
That said, regulators have not sounded the alarm in response to this year’s capital decline, while a projection out to first-quarter (Q1) 2026 published by the Fed under a severely adverse scenario forecasts the CET1 ratio rising again to 10.4 percent. “The aggregate and individual bank post-stress CET1 capital ratios remain above the required minimum regulatory levels throughout the projection horizon,” the Fed noted, thus concluding that banks are still able to lend to households and businesses while remaining well above minimum capital requirements. “In aggregate, banks would have over $600 billion in capital above their minimum requirements, based on the quarter in which the aggregate capital decline is the largest.”
“While the severity of this year’s stress test is similar to last year’s, the test resulted in higher losses because bank balance sheets are somewhat riskier and expenses are higher,” the Fed’s vice chair for supervision, Michael S. Barr, stated, meanwhile, adding that the result was still “within the range” of recent stress tests. “The goal of our test is to help ensure that banks have enough capital to absorb losses in a highly stressful scenario. This test shows that they do,” Barr also noted while acknowledging that the three aforementioned factors suggest “required capital buffers should be larger”.
With the majority of the banks passing the stress test with ease, then, several of the biggest lenders have since announced their plans to raise their dividend payouts, as the capital they were previously holding as buffers can now be unlocked and distributed among their shareholders. JPMorgan Chase will reportedly boost its dividend for the third quarter by almost 9 percent to $1.25 per share, while the bank has also approved a new stock-buyback programme worth around $30 billion. Morgan Stanley similarly raised its dividend by close to 9 percent and approved a $20-billion buyback programme, while Wells Fargo will boost its dividend by a hefty 14 percent to 40 cents per share for Q3.
And although the 31 banks were largely given a clean bill of health, objections to the stress test were still forthcoming from key lenders, most notably Goldman Sachs. With the Fed concluding that the bank would lose more than $40 million from loans and that its CET1 ratio fared worse than most of its banking peers under a severely adverse scenario, an estimated $6 billion of capital is required for Goldman to absorb projected losses comfortably. And while the stress test calculated a 17.6-percent loss on existing loan balances on credit cards for the 31 banks overall, the loss for Goldman Sachs alone was recorded at 25.4 percent.
The bank has filed an official appeal with the Fed to challenge its results. “The year-over-year increase in our stress capital buffer does not seem to reflect the strategic evolution of our business and the continuous progress we’ve made to reduce our stress loss intensity,” Goldman’s chief executive officer, David Solomon, said in response to the test results. “Given this discrepancy, we are engaging with our regulators to better understand its determinations.”
JPMorgan Chase, meanwhile, issued a press release shortly after the stress-test results were announced to contend that, as per its own assessment, the Fed’s projection for the US’ largest bank’s revenues, expenses and losses that are excluded from net income (known as “other comprehensive income”) through 2026 “appears to be too large”. Should JPMorgan’s analysis be correct, the resulting stress losses “would be modestly higher than those disclosed by the Federal Reserve”, the bank also noted. Nonetheless, with an expected loan loss rate (LLR) of 6.3 percent, the test results revealed that JPMorgan performed better than the 7.1-percent average for all 31 banks.
Whilst perhaps not a significant issue, JPMorgan’s response follows similar disclosures made last year by Bank of America and Citigroup that their projections of future income differed from the Fed’s. It also highlights the reservations that banks continue to hold regarding the potential opacity of the Fed’s stress-test methodology. Indeed, Goldman Sachs and several others have contended for years that the stress tests fail to acknowledge that a severe-recession scenario would trigger widespread cost savings by banks, including lower bonus payouts. In a statement to the Financial Times, the firm stated, “It’s not at all clear what factors would explain the diverging results year over year.”
Since the Fed began permitting banks to lodge appeals against stress-test results in 2020, eight banks have proceeded with challenges, but none have been successful to date. “There is little, if any, evidence that the reconsideration process for appealing stress test results or stress capital buffers provides any meaningful check on the Fed’s discretion,” Jonathan Gould, a financial markets lawyer at Jones Day and the former senior deputy comptroller and chief counsel of the Office of the Comptroller of the Currency (OCC), recently acknowledged in written testimony to the United States Committee on Financial Services.
Also, as part of the stress tests, the Fed conducted an “exploratory analysis” of only the eight biggest US banks regarding funding stresses under an adverse scenario that would involve the implosion of five large hedge funds. In such a situation, the big banks would lose between $70 billion and $85 billion. “The results demonstrated that these banks have material exposure to hedge funds but that they can withstand different types of trading book shocks,” the Fed explained.