The Federal Reserve just completed the results of its yearly stress testing, which subjected the country’s biggest banks to a variety of severe economic scenarios comparable to a deep recession.
The objective is to ensure that the banking sector is stable. This year, the Federal Reserve was not playing around. Between Q4 of 2021 and Q1 of 2024, the Fed’s theoretical scenario included unemployment increasing to 10% or more, commercial real estate prices declining by 40%, and stock values dropping by 55%.
All of the banks were put to the test, and all passed. The Fed determined that Bank of America (BAC -0.28%), the second-biggest bank in the United States, would have a pre-tax loss of around $44 billion during the nine-quarter time period in this hypothetical scenario, far exceeding any of the 33 banks that were tested. Should this worry investors?
Understanding this scenario
The Federal Reserve is essentially using assumptions about the economy in this hypothetical scenario, together with a slew of other assumptions, to figure out how a bank would operate under stress. One thing to bear in mind is that the Fed is employing a variety of assumptions in these theoretical situations that I am sure bank executives would not agree with. Furthermore, this is speculative. The unemployment rate presently stands at 3.6 percent, and no one expects it to rise above 10% anytime soon.
However, the Fed does this for a different purpose. The Great Recession caught everyone off guard, so this test is used to ensure that banks are adequately prepared and capitalized to face a severe recession.
In the Fed’s model, Bank of America will produce more than $28 billion in pre-provision net income during this nine-quarter period. The bank, on the other hand, would suffer from having to set aside over $53 billion for possible loan losses over the course of the nine quarters, which detracts from earnings.
The Fed believes that the loan losses would amount to $52.5 billion during the stressed period, with more than $13 billion in credit card loans and over $8 billion in commercial real estate.
I was expecting industrial and commercial loans, which are issued to businesses for things such as capital expenditures and working capital, to take a significant hit from the Fed’s projections that Bank of America would suffer more than $17 billion in C&I book losses.
Another consideration is that Bank of America’s credit card portfolio has a 16% loss rate in the Fed’s scenario. Given that credit card loan losses reached nearly 11% during the Great Depression, this looks rather severe.
Close to $13 billion of counterparty and trading losses are estimated during the time, which stems from BOA’s investment banking division as well as holding financial instruments like derivatives.
In terms of money, the Fed considers how a bank’s common equity tier 1 capital ratio would change under these circumstances. The core capital ratio is a metric that banks and regulators watch closely. It is the proportion of risk-weighted assets, like loans, included in a bank’s regulatory capital ratio.
Each, the Fed establishes minimum CET1 ratios for banks to comply with, and these are based in part on this stress testing. CET1 capital is employed to absorb any unexpected loan losses. The Fed discovered that Bank of America’s CET1 ratio would begin the stressed period at 10.6 percent and decrease to 7.6 percent during the test, which is above the 4.5 % CET1 requirement that all banks must meet.