They also hold enough capital that, even if faced with billions of dollars in losses from loans as a result of an economic crisis, they would continue to function.
The stress tests were created in the wake of the financial crisis and subsequent great recession. The implosion of the housing market led the US into its worse economic downturn since the Depression. Several large banks failed or were bought in rescue operations. The losses were so great that US taxpayers had to come to the rescue, at a cost of 700 billion dollars (£476 billion).
To keep that from happening again, Congress passed the Dodd-Frank financial reform laws in 2010. The law mandated the nation’s largest banks to simplify their structure and raise more capital, and that the nation’s bank regulators had to routinely monitor and test to make sure banks could withstand even the worst possible outcomes. The stress tests have become a mandated annual requirement.
Under the Fed’s most extreme scenario in this year’s test, the US economy falls into a deep recession causing the stock market to plunge by 50%, while u nemployment climbs above 10%, housing prices drop by 25% and commercial real estate prices fall by 30%. Investors, in this scenario, would be so panicked that yields on short-term US Treasuries would go negative – meaning even the safest of assets would still lose money.
Federal Reserve officials change the stress tests each year to mirror what economic climate the world is currently experiencing.
Other central banks have attempted negative interest rates, including the European Central Bank and Bank of Japan, to stimulate economic growth. So testing the largest US financial institutions under negative interest rates is not outside the realm of possibilities.
The Fed said that the nation’s 33 largest banks would have 526 billion dollars (£356 billion) in loan losses under the most extreme scenario. But even with those losses, all the banks would still hold collectively a high-quality capital ratio of 8.4%, well above the 4.5% minimum. Capital ratios are an industry standard of how strong a financial institution is.
The bank that came closest to not meeting the Fed’s minimum was Huntington Bancshares, which had a stressed ratio of 5%, followed by BMO Financial, with a stressed ratio of 5.9%.
The nation’s largest banks, and those with the largest amount of tradeable assets, would be still be hit hard under the Fed’s scenario. Goldman Sachs’ capital ratio would fall from 13.6% to 8.4%, Morgan Stanley’s ratio would fall nearly in half, from 16.4% to 9.1%. While these would be steep drops, they are still above the minimums.
The announcement is one part of two from the Fed regarding the stress tests. The more important announcement comes next week, when the Fed releases the results for each of the individual banks. If the banks pass, they will be allowed to raise their quarterly dividends and buy back shares.