The Federal Reserve recently released the results of its annual stress tests, in which it subjects the nation’s largest banks to a set of severe hypothetical economic conditions akin to a severe recession.
The objective is to ensure that the country’s banking system rests on sound foundations. This year, the Fed wasn’t kidding. Between the fourth quarter of 2021 and the first quarter of 2024, the Fed’s hypothetical scenario called for unemployment to rise above 10%, commercial real estate prices to fall by 40% and stock prices to fall. by 55%.
All the banks submitted to the test passed but were still bored. In particular, the Fed calculated that Bank of America (BAC 0.72%), the second-largest bank in the United States, would suffer a hefty pre-tax loss of nearly $44 billion over the nine-quarter period in the hypothetical scenario, more than any of the 33 banks tested. So should investors be worried?
Understand the scenario
What the Fed essentially does is use the economic assumptions from its “what-if” scenario, along with many other assumptions, to model a bank’s performance during the crisis period. One thing to understand is that there are a lot of assumptions the Fed is making that I’m sure bank executives would disagree with in these modeled scenarios. Moreover, it is completely hypothetical. The unemployment rate is currently very healthy at 3.6%, and no one expects it to top 10% anytime soon.
But the reason the Fed is doing this stems from the Great Recession. Everyone was caught off guard by the poor preparation of the banks. This exercise therefore aims to ensure that the banks are properly capitalized and prepared to face an intense recessionary environment.
The Fed’s model revealed that over this nine-quarter period, Bank of America would actually make pre-provision net income of more than $28 billion. However, the bank’s loss would come from having to provision more than $53 billion for potential loan losses over the nine quarters, which directly reduces net income.
As you can see, the Fed projects that actual loan losses would total $52.5 billion during the crisis period, including nearly $13 billion in credit card loans and more than $8 billion in lending. commercial real estate.
I thought commercial and industrial loans, which are the ones given to businesses for things like working capital and capital expenditures, were hit extremely hard, with the Fed projecting that Bank of America would take over $17 billion from losses in its C&I book.
The other thing to consider is that Bank of America’s credit card portfolio loss rate in the Fed scenario is close to 16%. That seems pretty harsh, given that credit card loan losses peaked at around 11% during the Great Recession.
The Fed also modeled nearly $13 billion in trading and counterparty losses during the period, which stem from Bank of America’s investment banking division and holdings of financial instruments such as derivatives. .
In terms of capital, the Fed is also looking at how banks’ Common Equity Tier 1 (CET1) ratio would evolve under this type of stress. CET1 is the primary regulator of the regulatory capital ratio and investors monitor and is a measure of a bank’s capital base expressed as a percentage of risk-weighted assets such as loans.
Each year, the Fed sets minimum CET1 ratios for banks to maintain, part of which is determined by these stress tests. CET1 capital is used to absorb unexpected loan losses. The Fed found that Bank of America’s CET1 ratio would start the stress period at 10.6% and bottom out at 7.6%, which is still above the base CET1 requirement of 4.5. % that all banks have.
Should investors be worried?
I want to repeat that this is all hypothetical. Additionally, being able to sustain over $52.5 billion in loan losses and maintain a strong CET1 ratio is good news and means Bank of America could survive a very severe economic shock.
But following the blow the bank suffered in this test, Bank of America will likely see its CET1 ratio requirement increase.
Banks are expected to announce their new projected CET1 requirements and dividend plans on Monday, June 27. A higher CET1 requirement means less excess capital, which is how banks primarily fund dividends and stock buybacks, so Bank of America could see its capital return plans slow. this year or be much more modest than last year.