Fed Stress Test 2024: Large Banks Face Greater Losses But Maintain Strong Capital Positions In Severe Recession Scenario (CORRECTED) – SPDR Select Sector Fund – Financial (ARCA:XLF)

Editor’s note: This story erroneously included stock information for Citizens Inc. rather than Citizens Financial Group Inc, which is the company mentioned in the Federal Reserve’s stress test report, and has been corrected.

The Federal Reserve Board’s annual bank stress test Wednesday reveals that while large banks face greater projected losses than last year in a downturn scenario, they remain well-positioned to endure a severe recession and maintain their capital requirements above minimum thresholds.

“This year’s stress test shows that large banks have sufficient capital to withstand a highly stressful scenario and meet their minimum capital ratios,” said the Fed’s vice chair for supervision Michael S. Barr.

Although this year’s stress test adverse scenario is as severe as last year’s, it resulted in greater losses due to slightly riskier bank balance sheets and increased expenses, he said.

Reflecting on the 2023 regional bank crisis, Barr emphasized that important lessons have been learned.

The Fed stated that “large banks are generally well-positioned to withstand a sudden funding shock in the form of shifting deposits.” Additionally, bank net interest income remains resilient in a high-rate environment, even when factoring in the funding shock assumptions.

2024 Bank Stress Test Details, Results

This year’s test showed that all 31 banks remained above their minimum common equity tier 1 (CET1) capital requirements despite total projected hypothetical losses nearing $685 billion.

The hypothetical scenario for this year’s test mirrors last year’s severe global recession test, including a 40% decline in commercial real estate prices, a significant rise in office vacancies and a 36% drop in house prices. The unemployment rate peaks at 10% in the stress test, with a corresponding decline in economic output.

Under the stress scenario, the aggregate CET1 capital ratio is expected to decline by 2.8 percentage points, from 12.7% to 9.9%. Although this is a greater decline than last year’s test, it remains within the range of recent tests.

Three main factors contribute to the larger capital decline in this year’s test:

1. Increased Credit Card Losses: A substantial rise in credit card balances and higher delinquency rates lead to greater projected credit card losses. The banks most exposed to credit card losses were Ally Financial Inc. ALLY, Discover Financial Services DFS and Goldman Sachs GS.
2. Riskier Corporate Credit Portfolios: Banks have downgraded their corporate loans, reflecting increased risk and resulting in higher projected corporate losses. Banks set to face the largest impact on their corporate loan balances are Discover Financial Services, Barclays plc BCS and Citizens Financial Group Inc CFG.
3. Higher Expenses and Lower Fee Income: Reduced projected income from higher expenses and lower fee income exacerbates the capital decline.

The projected losses include $175 billion in credit card losses, $142 billion from commercial and industrial loans and $77 billion from commercial real estate.

“Large bank exposure to commercial real estate (CRE) debt remains an area of focus for Federal Reserve supervisors,” the report says.

The 2024 supervisory severely adverse scenario includes increased stress in commercial real estate (CRE), with a 40% drop in CRE prices.

Although projected losses on loans to office properties have risen due to worsening fundamentals in the office segment, the Fed said these losses are balanced by a decrease in projected losses on loans to hotels and retail properties, as market fundamentals for these sectors have improved over the last year.

Market Reactions: Capital One Financial Corp COF, Citizens Financial Group and Goldman Sachs were among the worst performers of the Financial Select Sector SPDR Fund XLF components in after-market trading as of 5:05 p.m. ET. The top performer was Truist Financial Corp. TFC, up 1.7%

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