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Explainer: What’s new in the Fed’s bank stress tests in 2022?

WASHINGTON, June 23 (Reuters) – The Federal Reserve is due to release the results of its annual bank health checks on Thursday. As part of the “stress test,” the Fed examines bank balance sheets for a hypothetical severe economic downturn, the elements of which change annually.

The results dictate how much capital banks need to be healthy and how much they can return to shareholders via share buybacks and dividends.

WHY “STRESS TEST” THE FED BANKS?

The Fed introduced the tests after the 2007-2009 financial crisis as a tool to ensure banks could withstand a similar shock in the future. Testing officially began in 2011, and major lenders initially struggled to pass the test.

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Citigroup Inc (CN), Bank of America Corp. (BAC.N), JPMorgan Chase & Co (JPM.N) and Goldman Sachs Group Inc (GS.N), for example, have all had to adjust their capital plans to address Fed concerns. Deutsche Bank’s US subsidiary failed the “qualitative” aspect of the test, which assessed banks’ operational controls, in 2015, 2016 and 2018.

However, years of practice have made banks more adept at handling the tests, and under its former Republican leadership, the Fed has made the tests more transparent and dropped the “qualitative” aspect. It also ended much of the drama of the tests by doing away with the “pass-fail” model and introducing a more differentiated, bank-specific capital regime.

HOW ARE BANKS RATING NOW?

The test assesses whether banks would remain above the required minimum capital ratio of 4.5% during the hypothetical downturn. Banks that perform well tend to stay well above it.

How well a bank performs on the test is also determined by the size of its “stress capital buffer”, an additional layer of capital introduced in 2020, above the 4.5% minimum.

This additional cushion is determined by each bank’s hypothetical losses. The greater the losses, the greater the buffer. Continue reading

THE ROLLOUT

The Fed will release results on Thursday after the market close. It usually publishes the capital ratios and total losses of each bank under test, with details on how their specific portfolios — like credit cards or mortgages — performed.

However, banks are not allowed to announce their plans for dividends and buybacks until the following Monday, June 27th. The Fed will announce the level of each bank’s stressed capital buffer in the coming months.

The country’s largest lenders, notably JPMorgan, Citi, Wells Fargo & Co (WFC.N), Bank of America, Goldman Sachs and Morgan Stanley (MS.N), are being closely watched by the markets.

A HARDER TEST?

The Fed changes scenarios every year. They take months to develop, which means they risk becoming obsolete. In 2020, for example, the real economic crash caused by the COVID-19 pandemic was more severe than the Fed’s scenario this year by many measures.

The Fed developed this year’s scenario ahead of Russia’s invasion of Ukraine and the current hyperinflationary outlook.

Nonetheless, the 2022 test is expected to be more difficult than last year as the actual economic backdrop is healthier. This means that spikes in unemployment and declines in the size of the audited economy are more felt.

For example, the 2021 stress test called for a 4 percentage point increase in unemployment in a “very negative” scenario. In 2022, this increase will be 5.75 percentage points, which is mainly due to the increase in employment over the past year.

As a result, analysts expect banks to be asked to set aside slightly more capital than in 2021 to accommodate expected growth in modeled losses.

COMMERCIAL REAL ESTATE CHARGES, CORPORATE DEBT

This year’s tests also include “elevated stress” on commercial real estate, which has been hit by the pandemic, as workers have been sent home, and on corporate bond markets. Global watchdogs, including the International Monetary Fund, are warning of high levels of risky corporate debt as interest rates rise around the world.

ALL BANKS TESTED

In 2022, all 34 US banks monitored by the Fed with assets in excess of $100 billion will be subject to the stress test, compared to 23 lenders last year.

That’s because the Fed passed a new standard in 2020 that requires banks with assets under $250 billion only to take the test every two years. That means big regional banks like Ally Financial Inc (ALLY.N) and Fifth Third Bancorp (FITB.O) are back on the rise after a year’s hiatus.

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Reporting by Pete Schroeder; Editing by Michelle Price and Deepa Babington

Our standards: The Thomson Reuters Trust Principles.

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