2023 Stress Test Shows Bank Strength, Despite CRE Losses

The results of the 2023 Supervisory Stress Test conducted by the Federal Reserve indicate that the 23 large banks subjected to the test have ample capital to withstand challenging economic conditions. These banks can absorb over $540 billion in losses while still being able to provide loans to individuals and businesses.

This year's test, which was devised before the latest banking crisis, checked if banks would stay above the minimum 4.5% capital ratio during economic stress and macroeconomic instability.

Shares of the top performer in the test, Charles Schwab, rose 2.1%.

Big banks JPMorgan Chase, Wells Fargo, Morgan Stanley, Goldman Sachs and Bank of America gained between 1.4% and 3.2%.

The stress test reveals that both the combined and individual bank post-stress common equity tier 1 (CET1) capital ratios remain comfortably above the required minimum levels throughout the projection period. All banks tested remained above their minimum capital requirements, despite total projected losses of $612 billion. Under stress, the aggregate common equity capital ratio—which provides a cushion against losses—is projected to decline by 2.7 percentage points to a minimum of 9.7 percent, which is still more than double the minimum requirement.

Under the severely adverse scenario, the aggregate CET1 capital ratio of the 23 banks initially declines from 12.4 percent in the fourth quarter of 2022 to a minimum of 10.1 percent. However, it eventually rises to 10.7 percent by the end of the projection horizon.

Comparing the results to previous years, the aggregate decline of 2.3 percentage points in the capital ratio this year is smaller than the decline of 2.7 percentage points observed last year but comparable to declines in recent years. Although the overall decline in the capital ratio was smaller, the impact varied across different types of banks.

The largest banks entered the stress test with significant unrealized losses on their securities portfolios, but these losses improved due to projected declines in interest rates. Consequently, the decline in capital ratios was relatively smaller for these banks.

On the other hand, banks with a focus on mortgages, credit cards, and commercial real estate experienced larger declines in their post-stress capital ratios this year.

In particular, the stress test made updates to the commercial real estate (CRE) loss given default (LGD) model to enhance its sensitivity to loan-specific variations in collateral value. This updated model now considers the impact of specific differences in collateral value on recoveries for defaulted loans.

The Financial Stability Report released in May 2023 emphasized the elevated prices in commercial real estate (CRE) and the potential for significant losses in property values, posing risks to banks. Although smaller banks not subjected to the supervisory stress test hold most of the bank CRE loans, the banks included in the stress test have approximately 20 percent of office and downtown retail CRE loans.

The stress test results confirm that these large banks possess sufficient capital to endure a severe downturn in the CRE market.

The severely adverse scenario of the stress test envisioned heightened stress in the CRE market, including a 40 percent decline in CRE prices. The scenario anticipates that the decline in CRE prices would mainly affect properties at high risk of income and asset value drops, such as offices affected by remote work or the hospitality sector impacted by reduced business travel.

The CRE market conditions have moved in different directions over the past few years, with elevated office vacancies and increasing office loss rates. While hotel vacancies reached their peak during the pandemic in 2020 and have been declining since then.

Under the severely adverse scenario, the banks are projected to incur $64.9 billion in losses on their CRE exposures, equivalent to 8.8 percent of average balances. Although the projected CRE loss rates have decreased since 2020 due to the recovery of the hospitality sector from pandemic-related stress, they remain high.

Loss rates in the office sector continue to rise due to the current stress in office market fundamentals and the anticipated further deterioration in the scenario. For instance, this year's scenario predicts an office loss rate of approximately 20 percent in the event of a recession, surpassing the peak loss rate observed during the global financial crisis of 2007-2009.

Despite these severe losses, each bank possesses sufficient capital to maintain operations above the regulatory capital requirements. To ensure the stability and resilience of the banking system, Federal Reserve supervisors have intensified their evaluation of banks

While the test results paved the way for more dividends and buybacks, Wall Street analysts warned an uncertain economy and banks awaiting regulatory clarity will lead to limited shareholder returns in the near-term.

"Upcoming regulations will likely lead to higher capital requirements for all banks above $100 billion of assets," said analysts at Jefferies, adding that many banks have already pulled back on capital return.

Goldman Sachs analysts said market focus will likely return quickly to potential increases to stress capital buffer and tougher regulations against the backdrop of Basel III revision.