After subjecting the nation’s largest banks to a series of hypothetical economic and financial shocks, the Federal Reserve Board reported last week that those institutions are “well positioned to weather a severe recession and to continue to lend to households and businesses…”
Scenarios posed in the Fed’s annual stress test included assumptions of a severe global recession, unemployment climbing to 10%, and a dramatic decline in real estate prices.
Despite three major bank failures this year, the results of the annual bank stress test “confirm that the banking system” remains robust, Vice Chair for Supervision Michael S. Barr said.
“At the same time, this stress test is only one way to measure that strength,” Barr added. “We should remain humble about how risks can arise and continue our work to ensure that banks are resilient to a range of economic scenarios, market shocks, and other stresses.”
Federal regulators began performing the stress test – a banking ‘report card’ – after the 2008 financial crisis.
The stress test is one tool to help ensure that large banks can support the economy during economic downturns. The test evaluates the resilience of large banks by estimating their capital levels, losses, revenue and expenses under a single hypothetical recession and financial market shock, using banks’ data as of the end of last year.
All 23 banks tested remained above their minimum capital requirements during the hypothetical recession.
This year’s test included a severe global recession in which commercial real estate prices plunged by 40%, coupled with a substantial increase in office vacancies and a 38% decline in housing prices, unemployment rising to a peak of 10% and economic output declining commensurately.
The test’s focus on commercial real estate showed that while large banks would experience heavy losses in the hypothetical scenario, they still would be able to continue lending.
The banks in this year’s test have approximately 20% of the office and downtown commercial real estate loans held by banks. The large projected decline in commercial real estate prices, combined with the substantial increase in office vacancies, contributed to projected loss rates on office properties that are roughly triple the levels reached during the 2008 financial crisis.
For the first time, regulators also explored whether the eight banks that are most heavily involved in trading stocks, bonds and other financial products could withstand a sudden panic in those markets.
The individual results from the stress test factor directly into a bank’s capital requirements, requiring each institution to hold enough capital to survive a severe recession and financial market shock. If a bank does not stay above its capital requirements, it is subject to automatic restrictions on capital distributions and discretionary bonus payments.
The stress-test results were not all rosy. The report exposed relative weakness among midsize banks and “super-regional” banks.
Federal Reserve Chairman Jerome Powell said tighter oversight may be required in view of the failure of three midsize banks this year. Silicon Valley Bank in Santa Clara, California, collapsed on March 10; Signature Bank in New York on March 12; and First Republic Bank in San Francisco on May 1.
Although Powell said the U.S. banking system is “strong and resilient,” he neglected to note that in March, in response to a run on the two midsized regional banks, the federal government guaranteed the deposits of corporations and individuals that exceeded FDIC limits.
A 40% drop in commercial real estate prices could be disastrous to midsized and smaller banks that have significant exposure to the commercial real estate sector. In its latest Financial Stability Report, the Federal Reserve said 60% of commercial real estate loans are held by banks with less than $100 billion in assets, which includes all but the 37 largest U.S. banks.
An additional factor is that the Fed’s 10 consecutive increases in interest rates, to 5%-5.25%, are contributing to a slowdown in the housing construction industry.