Moments ago the Fed released the first phase of its annual stress test which, once again, found that all thirty-four of the US largest banks "passed", exceeding minimum projected capital and leverage ratios under severely adverse scenarios, based on their projected ability to withstand economic shocks, which as Bloomberg notes, shows that "firms are getting the hang of the once-dreaded reviews." The result marks the third straight year all firms cleared the minimum requirements in the exams’ first phase, begging the question just how "stressful" this test truly is.
Of the participant banks, every single one exceeded minimum thresholds, although Morgan Stanley trailed the rest of Wall Street on a key measure of leverage, the second year it performed worse than peers on this key metrics. During the second phase of last year's stress test the bank was forced to resubmit its plan to address a “material weakness”, before it was allowed to pay out capital to shareholders. Results from that round are due next week.
One notable finding: in the Fed's forecasts for loan losses in a "severely" adverse scenario, Goldman’s projected loan-loss rate of 8.1% was surpassed only by commercial lenders or card issuers such as American Express, Capital One, and Discover Financial Services. Wells Fargo & Co.’s $7.7 billion in trading and counterparty losses came close to firms with larger Wall Street operations, with Morgan Stanley at $9.5 billion. JPMorgan Chase & Co. led the group with $25.2 billion in losses.
“This year’s results show that, even during a severe recession, our large banks would remain well capitalized,” Fed Governor Jerome Powell said in a statement announcing the central bank’s findings Thursday.
It remains to be seen if that will also be the case when over $2 trillion in excess reserves which pad the bank's balance sheets are eventually drained.
The "successful" outcome will boost the industry's arguments that the banking system is safe enough to allow for cutting back some regulations. Furthermore, once the second round is released, expect all banks to further boost payouts to investors.
The "test" designed to boost confidence in the banking sector after the financial crisis, assesses how banks would handle hypothetical turmoil, such as surging unemployment, a sharp drop in housing prices or an extended stock slump. Firms that handily clear the first phase typically have more room to make payouts to shareholders.
The tests have become less dramatic in recent years with fewer quantitative failures. And under regulators selected by President Donald Trump, that may continue. The Treasury Department issued a report last week proposing tests occur less frequently, that highly capitalized banks be exempt from the process and that one of the toughest hurdles be scrapped.
Today's results covered the "Dodd-Frank Act Stress Test" that measures banks’ capital under stress over nine quarters. This year, the Fed projected supplementary leverage ratios at the largest banks. Morgan Stanley’s projected 3.8 percent ratio in a potential economic downturn was lowest - though it still cleared the 3 percent minimum, according to Bloomberg.
Here are the parameters for what the Fed defined as the "Severely Adverse", or worst-case, scenario:
The adverse scenario is characterized by weakening economic activity across all of the economies included in the scenario. This economic downturn is accompanied by a global aversion to long-term fixed-income assets that, despite lower short rates, brings about a near-term rise in long-term rates and steepening yield curves in the United States and the four countries/country blocks in the scenario.
The severely adverse scenario is characterized by a severe global recession that is accompanied by a period of heightened stress in corporate loan markets and commercial real estate markets. In this scenario, the level of U.S. real GDP begins to decline in the first quarter of 2017 and reaches a trough in the second quarter of 2018 that is about 6½ percent below the pre-recession peak. The unemployment rate increases by about 5¼ percentage points, to 10 percent, by the third quarter of 2018. Headline consumer price inflation falls to about 1¼ percent at an annual rate by the second quarter of 2017 and then rises to about 1¾ percent at an annual rate by the middle of 2018.
As a result of the severe decline in real activity, short-term Treasury rates fall and remain near zero through the end of the scenario period. The 10-year Treasury yield drops to ¾ percent in the first quarter of 2017, rising gradually thereafter to around 1½ percent by the first quarter of 2019 and to about 1¾ percent by the first quarter of 2020. Financial conditions in corporate and real estate lending markets are stressed severely. The spread between yields on investment-grade corporate bonds and yields on long-term Treasury securities widens to about 5½ percentage points by the end of 2017, an increase of 3½ percentage points relative to the fourth quarter of 2016. The spread between mortgage rates and 10-year Treasury yields widens to over 3½ percentage points over the same time period.
Asset prices drop sharply in this scenario. Equity prices fall by 50 percent through the end of 2017, accompanied by a surge in equity market volatility, which approaches the levels attained in 2008. House prices and commercial real estate prices also experience large declines, with house prices and commercial real estate prices falling by 25 percent and 35 percent, respectively, through the first quarter of 2019.
The international component of this scenario features severe recessions in the euro area, the United Kingdom, and Japan and a marked growth slowdown in developing Asia. As a result of the sharp contraction in economic activity, all foreign economies included in the scenario experience a decline in consumer prices. As in this year’s adverse scenario, the U.S. dollar appreciates against the euro, the pound sterling, and the currencies of developing Asia but depreciates modestly against the yen because of flight-to-safety capital flows.
In other words, neither inflation, nor 10Y yields drop negative even as VIX surges to 70. Mmmk then.
And here is the VIX scenario that the Fed believes all banks will survive:
Some other findings courtesy of Bloomberg:
- Firms boosted share of agency MBS, Treasuries in securities portfolios, cut holdings of less-liquid assets like securitized products
- Loan portfolios grew, driven by strong growth in corporate, commercial real estate (CRE), credit-card loans
- Residential mortgage growth lagged, as healthy growth in first-lien mortgages was offset by notable decline in home- equity loans
- Credit quality of some loan portfolios -- including first-lien mortgages and commercial mortgages -- has improved, largely due to recent gains in real estate prices
- At the same time, improvements in portfolios secured by real estate were partially offset by continued stress on some corporate loans due to persistently low oil prices, recent uptick in delinquency rates in credit-card portfolios
- Results overall show banks have strong capital levels, retain ability to lend to households and businesses during severe recession
- Most-severe hypothetical scenario projects $493b in losses at the 34 participating banks during the 9 quarters tested, with $383b in accrual loan portfolio losses, $86b in trading and/or counterparty losses at the 8 cos. with substantial trading, processing, custodial operations
- Companies’ aggregate common equity tier 1 capital ratio would fall to minimum level of 9.2% from actual 12.5% in 4Q 2016
- In "adverse" scenario (featuring moderate recession), aggregate common equity capital ratio fell to minimum 10.7% from actual 12.5% in 4Q
- Since 2009, the firms have added >$750b in common equity capital
On June 28, at 4:30pm, the Fed will release the results of the second round of the Stress Test, the Comprehensive Capital Analysis and Review (CCAR).