By Stephanie K. Mann, J.D.
The ability of the largest financial institutions to persist through a potential future recession continues to strengthen, says the latest stress tests results released by the Federal Reserve Board. On March 5, 2015, the Fed released the “Dodd-Frank Act Stress Test 2015: Supervisory Stress Test Methodology and Results,” which includes hypothetical scenarios to project loan losses. The 31 firms tested represent more than 80 percent of domestic banking assets.
As Fed Governor Daniel K. Tarullo explained, “supervisory stress tests are designed to ensure that these banks have enough capital that they could continue to lend to American businesses and households even in a severe economic downturn.” The severely adverse scenario projected that loan losses would total $340 billion during the nine quarters tested. This is an improvement over the first year of testing, in 2009, where aggregate tier 1 common capital ratio was 5.5 percent as measured.
Background. Large, complex bank holding companies are required to have sufficient capital to continue lending to support real economic activity while meeting their financial obligations, even under stressful economic conditions. Stress testing is one tool that helps bank supervisors measure whether a BHC has enough capital to support its operations throughout periods of stress. "Higher capital levels at large banks increase the resiliency of our financial system," said Tarullo.
Severely adverse scenario. The most severely adverse scenario shows a deep recession with an unemployment rate of 10 percent, a decline in home prices of 25 percent, a stock market drop of nearly 60 percent, and a rise in market volatility. Projections include:
- loan losses would total $340 billion;
- aggregate tier 1 common capital ratio would fall from an actual 11.9 percent in the third quarter of 2014 to a minimum level of 8.2 percent in the hypothetical stress scenario;
- $340 billion in accrual loan portfolio losses;
- $18 billion in other than temporary impairment (OTTI) and other realized securities losses;
- $103 billion in trading and/or counterparty losses at the eight BHCs with substantial trading, processing, or custodial operations; and
- $29 billion in additional losses from items such as loans booked under the fair-value option.
Adverse scenario. The adverse scenario features a more moderate recession, but a rapid increase in short- and long-term interest rates. Results showed that aggregate tier 1 common capital ratio of all 31 firms would fall from an actual 11.9 percent in the third quarter of 2014 to the minimum level of 10.8 percent. Results included:
- $235 billion in accrual loan losses;
- $9 billion in OTTI and other realized securities losses;
- $55 billion in losses from the global market shock and the largest counterparty default components; and
- $16 billion in additional losses from items such as loans booked under the fair-value option.
