Explained: What’s new with the Fed’s bank stress tests in 2022

The US Federal Reserve will release the results of its annual bank health checks on Thursday. As part of a “stress test” exercise created in the aftermath of the 2007-2009 financial crisis, the Fed is testing banks’ balance sheets against a supposedly severe economic downturn, the elements of which change annually.

The results determine how much capital banks need to be in a healthy state and how much they can return to shareholders through share buybacks and dividends.

How well a bank performs determines the size of the “temporary capital buffer” – the extra capital cushion the Fed needs to counteract a default deflation, as well as the regulatory minimum needed to support day-to-day business. The higher the losses under test, the higher the buffer.

Here are the highlights of this year’s exams:
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The Federal Reserve is expected to release results after the market closes on Thursday. Rather than pass or fail lenders, it typically publishes each bank’s capital ratios and total losses under test, with details of how their specific portfolios — such as credit cards or mortgages — are performing. However, banks are not allowed to announce their dividend and buyback plans until the following Monday, June 27.

Markets are closely watching the country’s largest lenders, notably JPMorgan Chase & Co, Citigroup Inc, Wells Fargo & Co and Bank of America Corp. and Goldman Sachs Group Inc and Morgan Stanley.

Tough test?
The Fed changes scenarios every year. It takes months to create them, which means they risk becoming obsolete. In 2020, for example, the real economic meltdown caused by the COVID-19 pandemic was much more severe than the Fed’s scenario that year. The Fed laid out this year’s scenario before the Russian invasion of Ukraine and the current expectations of hyperinflation.

However, the 2022 test is expected to be more difficult than last year because the actual economic basis is more correct. This means that sudden rises in unemployment and declines in the size of the economy under test are becoming more severe.

For example, the 2021 stress test depicted a 4 percentage point jump in unemployment under a “severely opposite” scenario. In 2022, that increase was 5.75 percentage points, thanks in large part to an increase in hiring over the past year. As a result, analysts expect banks to be required to allocate slightly more capital than in 2021 to account for projected growth in typical losses.

Pressures in commercial real estate and corporate debt
This year’s tests will also include “rising stress” in commercial real estate, which has been hit by the pandemic as workers are sent home, and corporate debt markets. Global watchdogs, including the International Monetary Fund, have warned of high levels of risky corporate debt as interest rates rise globally.

All banks tested
In 2022, all 34 US banks monitored by the Federal Reserve with more than $100 billion in assets will be subject to a stress test, compared to 23 lenders last year, because the Fed adopted a new standard in 2020 that states that banks with Less than $250 billion in assets should only be tested every two years. This means that large regional banks, such as Ally Financial Inc and Fifth Third Bancorp, are up again after a year of hiatus.

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