The U.S.' biggest banks passed the Federal Reserve's stress tests on Thursday, a vote of confidence in the financial sector despite signs that the country could be in a recession.
The Fed's stress tests showed that the banks have enough capital to withstand a severe economic downturn. They also allowed them to resume paying dividends and issuing share buybacks.
The Fed estimated that 34 of the country's biggest banks would suffer losses of about $612 billion under a severe economic downturn. Despite this, they would still be able to maintain their capital levels at about twice the levels required by the regulators.
Many major banks, such as Bank of America, Goldman Sachs, and Morgan Stanley, will be able to use their excess capital to pay dividends and repurchase shares. The plans to issue dividends and share buybacks will be announced after the market closes on Monday.
According to Jaret Seiberg, an analyst with Cowen Washington Research Group, the results of the stress tests were positive for the banks as they showed that they could weather a severe economic downturn. Seiberg noted that the banks would also be able to maintain their profitability even though the value of their assets would take a hit.
"We view this as about as positive for the big banks as one could expect from the annual stress test," Seiberg said. "Banks didn't just perform well. The test showed they could weather a severe downturn with plunging commercial real estate and equity values and surging unemployment levels."
Senator says banks need more rigorous stress tests
Despite the positive results of the stress tests, Senator Sherrod Brown of Ohio criticized the process, saying that it did not go far enough.
The Fed conducts stress tests yearly to see how banks would fare in a hypothetical economic downturn. The exercise results are used to determine how much capital banks need to maintain to be healthy.
Although the scenarios were created before the Ukraine crisis and the country's hyper-inflationary outlook, they should give policymakers and investors confidence that the banks are well-equipped to handle a potential recession.
The 34 banks that participated in the stress tests suffered substantial losses under the scenario created by the Fed. The economic decline was caused mainly by the collapse of the commercial real estate market and the rising unemployment rate. Despite the losses, the regulators noted that the banks' aggregate capital ratios were still well above the minimum requirements.
Strong results
In 2020, the Fed changed the way it conducted stress tests. Instead of relying on a pass-fail model, the regulators adopted a more complex approach that involved assessing the banks' capital levels. The test's goal is to ensure that the banks maintain their capital levels at a level that is well above the minimum requirements.
The Fed said that the 34 banks participating in the stress tests had a capital ratio of 9.7%. This is slightly higher than the 10.6% that the regulators found in last year's exercise. An analysis of the results by Reuters showed that the average capital ratio of the country's eight biggest banks was 9.94%.
Credit Suisse noted that the average stress capital buffer of the country's major banks is expected to increase to 3.3% in 2021. However, the amount of capital the banks are required to distribute to their shareholders is expected to decline by around 10% in 2022.