Imagine another economic crisis: The unemployment rate gets over 11%, stock prices drop nearly 50%, and housing prices fall 25%, causing the 30 largest banks to lose $366 billion in just over two years on their loans. This is the scenario the Federal Reserve imagined for its annual “stress test,” a simulation of how the country’s banking system, and especially those banks whose failure could threaten the entire economy, would withstand an economic shock comparable to the 2008 financial crisis.
This year’s review, released Thursday, and the fourth one since the passage of the Dodd-Frank financial reform bill, had 29 of 30 banks “passing,” meaning the value of their equity stayed at 5% of a measure of their risk-adjusted assets. The only one that failed, Utah-based Zions, would see its capital fall to 3.6% under the most extreme scenario. In the beginning of 2009, the 30 biggest banks saw their actual capital ratio decline to 5.5% — under the stress test, the 30 banks would see the ratio fall to its lowest at 7.6%.
Among the six largest banks, Wells Fargo had the highest capital ratio in the stress test with 8.2%, while Bank of America, JPMorgan Chase, Morgan Stanley, and Goldman Sachs all saw their ratios fall to below 7%, with Morgan Stanley being the lowest at 5.9%.
The poor results for the biggest banks with large trading books could be from a new feature of this year’s test, an assumption that the banks largest trading partner, or counter-party, would fail in an economic crisis.
This change is supposed to reflect how interconnected the largest banks are and to approximate a situation like 2008, where one large investment bank (Lehman Brothers) failed and AIG, which had extensive trading relationships with much of the financial system, needed a $182 billion bailout, a substantial chunk of which went to its trading partners.
The six megabanks also had to deal with a “global market shock,” where their trading private equity positions would take a large hit. So it’s not surprising that Wells Fargo, which despite being the fourth largest bank by assets is the least exposed to volatile trading assets and the world economy, is able to best weather under the global market meltdown.
JPMorgan, Citi, Bank of America, Morgan Stanley, and Goldman Sachs alone would suffer $83 billion in losses in trading from its largest counter-party failing, with JPMorgan taking the biggest hit at $24.2 billion in the most severe scenario envisioned by the Fed, while Wells Fargo’s estimated loss was only $5.9 billion.
Overall, however, the results reflect both the largest banks’ most important regulator, the Federal Reserve, specifically planning for a truly severe crisis and how the banks have adjusted to make themselves more resilient.
“The annual stress test is one of the Federal Reserve’s most important tools to gauge the resiliency of the financial sector and to help ensure that the largest firms have strong capital positions,” said Daniel Tarullo, the Federal Reserve governor in charge of regulation, in a statement. “Each year we are making substantial improvements, which have helped make the process even stronger than when we first conducted the stress tests in the midst of the financial crisis five years ago.”
The stress tests are the first part of an annual review where the Fed approves or denies bank’s plan to return money to shareholders through dividends or buybacks. Those decisions will be unveiled next week.