© Reuters. FILE PHOTO: The Federal Reserve Building on Constitution Avenue in Washington, U.S., March 19, 2019. REUTERS/Leah Millis/File Photo
by Peter Schroeder
WASHINGTON (Reuters) – The Federal Reserve will release the results of its annual bank health check on Thursday. In a “stress test” campaign established after the 2007-2009 financial crisis, the Fed tested banks’ balance sheets against a hypothetical severe recession, elements of which changed each year.
The results determine how much capital banks need to stay healthy and how much they can return to shareholders through share buybacks and dividends.
How a bank performs determines the size of its “stressed capital buffer” — the additional capital buffer the Fed needs to withstand a hypothetical recession, in addition to the minimum regulatory requirements needed to support day-to-day business. The greater the loss under test, the greater the buffer.
Here are the highlights of this year’s test:
The Fed is expected to report results after the market close on Thursday. It typically doesn’t publish passing or failing lenders, but instead publishes each bank’s capital ratios and total losses measured, detailing how its particular portfolio, such as credit cards or mortgages, is performing.
However, banks are not allowed to announce their dividend and buyback plans until the following Monday, June 27.
The country’s largest lenders, notably JPMorgan Chase (NYSE: ), Citigroup Corporation (NYSE: ), FuGuo bank (NYSE:) & Co, Bank of America Corp (NYSE:)., Goldman Sachs Group Corporation (NYSE: ) and Morgan Stanley (NYSE: ) is closely watched by the market.
A tougher test?
The Fed changes the scenario every year. They take months to design, which means they can become obsolete. For example, in 2020, the real economic collapse caused by the COVID-19 pandemic is in many ways more severe than the Fed’s scenario that year.
The Fed designed this year’s scenario ahead of Russia’s invasion of Ukraine and the current hyperinflation outlook.
Still, testing in 2022 is expected to be more difficult than last year, as the actual economic baseline is healthier. That means soaring unemployment and a decline in the size of the economy under test are felt more strongly.
For example, the 2021 stress test envisages a 4 percentage point rise in unemployment under a “severely adverse” scenario. By 2022, the increase is 5.75 percentage points, largely due to job gains over the past year.
As a result, analysts expect banks to be told to set aside slightly more capital than in 2021 to deal with an expected increase in simulated losses.
Commercial real estate, corporate debt pressure
This year’s tests will also include “increased stress” in commercial real estate, which has been hit by the pandemic as workers are being sent back, and in the corporate debt market. Global regulators, including the International Monetary Fund, have warned that risky corporate debt will remain elevated as global interest rates rise.
All banks are tested
All 34 U.S. banks with more than $100 billion in assets monitored by the Fed will be subject to stress tests by 2022, up from 23 last year.
That’s because the Fed adopted a new standard in 2020 that requires banks with less than $250 billion in assets to be tested only every other year. That means big regional banks like Ally Financial (NYSE:) Inc and Fifth Third Bancorp (NASDAQ: ) are up again after a one-year hiatus.