On Thursday, the Federal Reserve released the preliminary results of its annual stress test for the largest banks this Thursday. The tests found that bank holding companies with assets above $100 billion are well-capitalized and passed a simulated severe global recession.
“The most severe hypothetical scenario projects $578 billion in total losses for the 35 participating bank holding companies during the nine quarters tested. The “severely adverse” scenario, the most stringent scenario yet used in the Board’s stress tests, features a severe global recession with the U.S. unemployment rate rising by almost 6 percentage points to 10 percent, accompanied by a steepening Treasury yield curve.
The firms’ aggregate common equity tier 1 capital ratio, which compares high-quality capital to risk-weighted assets, would fall from an actual level of 12.3 percent in the fourth quarter of 2017 to a minimum level of 7.9 percent in the hypothetical stress scenario. Since 2009, the 35 firms have added about $800 billion in common equity capital.”
The most promising finding is that capital levels after the hypothetical recession are actually higher than they were leading up to the 2007-08 financial crisis. Some of the largest financial institutions, however, were less capitalized than their peers.
“Goldman Sachs and Morgan Stanley, for example, just cleared their supplementary leverage ratios—a measure that includes lending and derivative exposure relative to their capital levels. Goldman Sachs was 3.1% and Morgan Stanley 3.3%, compared with a 3.0% minimum.”
Next Thursday the Fed will release the second round of “quantitative” results discussing the capitalization of individual banks. High levels of equity financing are an essential tool to prevent insolvency and bankruptcy, and the level of bank equity financing remains too low despite the recent uptick.
The Minneapolis Fed’s plan to end too big to fail by phasing-in 23.5% capital requirements would reduce the chances of a bailout in the next century to only 9%, compared with the post-Dodd Frank chance of 67%.
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