NEW YORK, N.Y. – The largest U.S. financial institutions have enough armour to withstand the turmoil of a major and prolonged national and global recession, the Federal Reserve said Thursday.
The central bank’s annual “stress tests” show that the 33 largest financial institutions — including JPMorgan Chase, Citigroup, Bank of America and Wells Fargo — all hold more capital than at any time since the 2008 financial crisis. 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 U.S. into its worse economic downturn since the Great Depression. Several large banks failed or were bought in rescue operations. The losses were so great that U.S. taxpayers had to come to the rescue, at a cost of $700 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 simplify their structure, 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 became a mandated annual requirement.
Under the Fed’s most extreme scenario in this year’s test, the U.S. economy falls into a deep recession causing the stock market to plunge by 50 per cent. Unemployment climbs above 10 per cent, and housing prices drop by 25 per cent and commercial real estate prices fall by 30 per cent. Investors, in this scenario, would be so panicked that yields on short-term U.S. 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 U.S. 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 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 per cent, well above the 4.5 per cent 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 per cent, followed by BMO Financial, with a stressed ratio of 5.9 per cent.
The nation’s largest banks, and those with the largest amount of tradable assets, would be still be hit-hard under the Fed’s scenario. Goldman Sachs’ capital ratio would fall from 13.6 per cent to 8.4 per cent, Morgan Stanley’s ratio would fall nearly in half, from 16.4 per cent to 9.1 per cent. While steep drops, they are still above the minimums.
Thursday’s announcement is one part of two announcements by the Fed regarding the stress tests. The more important announcement comes next week, when the Fed will release 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.