Federal Reserve annual stress test results: Banks pass stress tests, paving the way for increased spending

Top U.S. banks delivered satisfactory results in the annual stress tests conducted by the Federal Reserve, not only opening the door to enhancing shareholder returns but also indicating a potentially more lenient capital regulatory environment for the banking industry.

On Wednesday, June 26th, Eastern Time, the Federal Reserve announced the results of the annual stress tests. The results showed that in a simulated economic recession scenario, all banks participating in the tests did not fall below the minimum capital requirements, despite facing potential losses of up to $685 billion. This figure, although significant, still falls within an acceptable range based on recent stress tests.

This year's annual stress tests covered 31 large banks, and the tests considered a series of "extremely adverse" economic scenarios, including a surge in U.S. unemployment to 10%, a 55% stock market crash, and a significant 40% decline in commercial real estate prices. Even under these extreme economic pressures, the banks' minimum common equity tier 1 capital ratio is expected to reach at least 9.9%, significantly higher than the regulatory minimum standard of 4.5%.

The release of the test results further demonstrates the resilience and stability of the U.S. banking industry in the face of potential economic risks, showing that banks have sufficient capital buffers. This not only enhances market confidence in the banking sector but also provides important reference points for policymakers, especially as discussions continue regarding lowering capital increase requirements to 5%.

Federal Reserve Vice Chairman Michael Barr affirmed the results, stating:

"Our stress tests are designed to ensure that banks have sufficient capital to withstand losses in extreme economic conditions. The results are encouraging and confirm the robustness of the banking system."

Banks Still Need to Increase Capital Buffers to Mitigate Future Risks

The stress test results also revealed significant variations in capital levels among different banks, despite all banks meeting regulatory requirements. JPMorgan Chase's CET1 ratio slightly decreased from 15% at the beginning of the year to 12.5%. On the other hand, Wells Fargo's CET1 ratio significantly dropped from 11.4% at the beginning of the year to 8.1%, the lowest among all large banks. This highlights the differences in internal capital management strategies and risk resilience within the banking industry.

When faced with challenges such as stock price declines, sharp increases in short-term Treasury yields, and dollar depreciation in the "global market shock" scenario, large U.S. banks demonstrated the strength of their accumulated additional capital. Despite banks' capital adequacy ratios far exceeding regulatory minimum requirements, Barr emphasized the necessity for banks to maintain high capital levels, stating:

"This underscores the importance of banks maintaining capital buffers above regulatory minimum requirements in recent years. These additional capital buffers give us confidence that large banks can continue to provide necessary credit support to households and businesses during financial turmoil. This not only enhances banks' ability to withstand risks but also provides a solid foundation for economic stability and development." "

In addition, Barr attributes the higher potential losses shown in this year's stress tests to several key factors, namely the rise in credit card balances and delinquency rates, increased corporate credit risk exposure, as well as the increase in costs and decrease in fee income in recent years, which together have squeezed banks' net income and reduced their ability to absorb losses. Barr believes:

"Given these factors, banks should further increase capital buffers to ensure they can remain robust in the face of economic pressures and have enough capital to support the credit needs of households and businesses."

Fed considers lowering capital increase to 5%, US banking sector increases stock buyback efforts

Since the last stress test, discussions on bank capital adequacy have sparked widespread and in-depth debates at the policy-making level. After the Federal Reserve announced stricter capital requirements for banks with assets over a trillion dollars last July, Wall Street banks engaged in a highly intense lobbying campaign to alleviate the pressure brought by the new rules. Bank executives believe they have met the capital adequacy requirements and that the new regulatory rules may have negative impacts on consumers and businesses. They actively sought significant modifications to the proposal or sought complete repeal. Federal Reserve Chairman Jerome Powell stated earlier this year that there would be "broad and substantive adjustments" to the proposal.

On June 25, the Federal Reserve recently submitted a draft proposal to the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency to lower the capital increase requirement proposed last year to 5%. This proposal aims to alleviate the capital pressure on the banking industry, but according to media reports, there is no consensus within the regulatory authorities on this revision, and the possibility of completing the revision plan before the November presidential election is uncertain.

While discussions at the regulatory level are ongoing, major US banks have shown confidence in their own capital levels. These banks have increased their stock buyback efforts this year, even before the results of the stress tests were announced. Specifically, the six largest banks repurchased over $14 billion in stocks in the first quarter of 2024, a 73% increase in buyback pace compared to the second half of last year. This move not only reflects the banking industry's confidence in its robust capital position but also indicates their optimism about future market developments.

The Federal Reserve stated on Wednesday that it hopes banks will wait until Friday afternoon at 4:30 to announce any plans regarding dividends and stock buybacks. The purpose of this is to give the market more time to digest and understand the impact of these plans.

In recent months, several bank executives have claimed to have excess capital. This includes an unexpected dividend increase from Morgan Stanley, with Morgan Stanley CEO Jamie Dimon stating, "Our cup runneth over with capital." This statement implies that banks have more capital than needed, allowing them to use this extra capital to increase shareholder returns, such as through increased dividends.

A senior official at the Federal Reserve indicated that based on the stress test results, the required stress capital buffer for banks (i.e., additional capital used to maintain bank stability in economic stress scenarios) will generally increase moderately. This means that although banks are currently well-capitalized, regulatory authorities still want banks to hold more capital as a safety cushion to better cope with potential future economic pressures.

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