Wall Street Faces Fed Stress Tests Assuming Global Recessionby
Worst-case scenario envisions 10 percent U.S. unemployment
Hypothetical conditions of tests meant to ensure resiliency
Wall Street banks will have to show they could survive a major global recession as part of an annual Federal Reserve exercise aimed at ensuring the biggest lenders aren’t vulnerable to a new financial crisis.
The stress test scenarios released Friday by the Fed will be used to determine whether firms such as JPMorgan Chase & Co., Goldman Sachs Group Inc. and Deutsche Bank AG are strong enough to withstand a major blow to the broader economy. Good performance could give banks more leeway to pay dividends to their shareholders and buy back stock.
The newly released scenarios feature the jobless rate climbing 5.25 percentage points to 10 percent and difficulties in corporate lending. Most midsize and smaller U.S. lenders will get a big break this year after the Fed said earlier this week that it would let them escape from one of the toughest parts of the exams.
Banks are required to submit their capital plans and stress test results to the Fed by April 5. The central bank said it will announce the results before the end of June.
The stress tests, which were introduced after the 2008 financial crisis, have driven capital levels higher as banks try to ensure they’re not among those buckling under the Fed’s nightmare scenarios. On Monday, the central bank said only the 13 biggest lenders will now face the so-called qualitative side of the tests, where many have been tripped up in the past.
The annual reviews required under the Dodd-Frank Act could be under a different sort of stress as President Donald Trump calls for a sweeping review of the 2010 law as part of an attack on what he sees as over-regulation. Though the stress tests weren’t specifically named, they were a core part in the post-crisis overhaul required by the law, and industry groups are waiting to see whether those and similar requirements get easier in the future.
Trump is also weighing nominations for key positions including Fed vice chairman for supervision, though Fed Chair Janet Yellen has said she intends to stay at the helm until her term expires next year.
In this year’s toughest stress-test scenario -- called “severely adverse” -- there would be a rise to 10 percent U.S. unemployment, a drop to near-zero interest rates and a global recession that would hammer corporate lending and commercial real estate, the Fed said. And in the less severe “adverse” scenario, banks would face a more moderate recession characterized by weaker economic activity across a wide swath of countries. The tests also subject banks to a baseline scenario that assumes conditions develop in line with economists’ forecasts.
The new rule exempting some regional banks and foreign lenders from the qualitative tests means they can’t be failed over their preparations for dealing with their management of capital and risk under crisis.
The greatest beneficiaries may be U.S. units of Deutsche Bank and Banco Santander SA, which both failed last year because of “broad and substantial weaknesses across their capital planning processes.” That’s no longer a worry for this year, through Deutsche Bank will again face the qualitative side next year when more of its U.S. operations are subjected to the tests.
The 21 regional and foreign banks that are now off the hook for the qualitative scrutiny still have to clear the quantitative side of the tests, meaning they must prove they can keep their capital above minimum levels in periods of economic stress.
On the quantitative side of the test, the banks try to stay above that defined capital minimum. On the qualitative side, the Fed examines the management of a firm’s capital as it faces the different risks.
For Wall Street banks, the annual process remains as tough as ever and often controls -- in real-world terms -- the amount of capital they work with. Banks with the largest trading operations face the additional burden of having to assume market shocks and trading-partner difficulties on top of their own adverse conditions.
Last year’s results showed all banks had enough capital to handle a severe economic shock, though Morgan Stanley had to shore up its internal systems because the firm was close to the minimum in a key measure of leverage. Most giant banks have been able to improve their results as they’ve gotten more comfortable with the tests, and as a result they’ve been able to boost quarterly dividends.
The Office of the Comptroller of the Currency also announced Friday it is using the same scenarios for the stress tests that agency oversees, which are self exams done by lenders with more than $10 billion in assets.