Treliant Takeaway…Federal Reserve Releases 2023 Stress Test Results

2023 Federal Reserve Stress Test Results

• Source: federalreserve.gov

Takeaway:

Treliant’s Risk Management Solutions practice comprises former senior financial services risk executives and regulators who combine their extensive experience, qualifications, and know-how to assist financial institutions in meeting the Federal Reserve’s stress testing expectations. We provide financial institutions consulting support on credit risk management and governance, stress testing, climate scenario analysis, ESG policy and procedure development, loan workouts, and advice on portfolio risk-mitigation strategies.

Highlights:

The U.S. Federal Reserve released the results of the 2023 annual stress tests on June 28, 2023 to ensure the resilience of the U.S. banking system. The results of the stress tests are meant to be educational to bank senior management and the regulators, including helping the Federal Reserve determine whether it could bolster future tests by applying multiple scenarios to companies to capture a wider array of risks.

The stress tests, a product of the Great Recession, are designed to determine if the nation’s 23 largest banks can withstand a severe global recession with heightened stress in both commercial and residential real estate markets, as well as in corporate debt markets. This year’s results are particularly significant, following the collapse of three U.S. banks that sent shockwaves through the global banking system.

Under this year’s scenario, the unemployment rate rose by 6.5 percentage points over the course of two years, a steeper rise compared to the previous test of 5.8 percentage points. Home prices are set to decline more sharply by 38 percent, versus the previous year’s decline of 28.5 percent. Commercial real estate, a growing concern for U.S. banks, was assumed to plunge by 40 percent in prices.

In a statement, the Federal Reserve said the 2023 test will include a new “exploratory market shock” for the eight largest banks, which will not affect their capital requirements but will further detail their resilience as well as help the Federal Reserve decide whether it should pursue multiple test scenarios in future years.

2023 Stress Test Results

The results of its annual bank stress test, which demonstrates that large banks are well positioned to weather a severe recession and continue to lend to households and businesses even during a severe recession. All 23 banks tested remained above their minimum capital requirements during the hypothetical recession, despite total projected losses of $541 billion. Under stress, the aggregate common equity risk-based capital ratio—which provides a cushion against losses—is projected to decline by 2.3 percentage points to a minimum of 10.1 percent. The aggregate 2.3 percentage point decline in capital is slightly less than the 2.7 percentage point decline from last year’s test but is comparable to declines projected from the stress test in recent years. While the decline in the aggregate capital ratio was smaller this year than last, the results vary significantly across different types of banks.

For the first time, the Federal Reserve conducted an exploratory market shock on the trading books of the largest banks, testing them against greater inflationary pressures and rising interest rates. This exploratory market shock will not contribute to banks’ capital requirements but was used to further understand the risks with their trading activities and to assess the potential for testing banks against multiple scenarios in the future. The results showed that the largest banks’ trading books were resilient to the rising rate environment tested.

The 2023 stress test results demonstrate that large banks continue to have sufficient capital to withstand a severe commercial real estate downturn.

Demonstrating capital adequacy in the stress test does not mean a bank can relax when it comes to capital planning and stress testing. Still expected in coming months are increased regulations on regional banks because of the bank failures in March 2023 as well as tighter international standards likely to boost capital requirements for the U.S. largest banks.