Last Thursday, the Federal Reserve published the results of the 2016 Dodd-Frank Act Bank Stress Test. The top 33 banks operating in the U.S. are all doing quite well and are now far stronger than they have been in some time. This test was developed after the financial crisis as a way to determine if banks could survive another recession without needing a government bailout. It really should be renamed the “No More Bailouts Test.”
This stress test is one of the best bits of regulation to come out of the crisis. It has always been difficult to tell what risks a bank is taking and what might happen in a downturn. Because in this very detailed test the scenarios and the haircuts are the same for all banks, the results are apples to apples. And the scenarios have some bite! The Severely Adverse Scenario assumes in part the unemployment rate rises to over 10%, home prices decline 25% and the stock market falls 50%.
While this test is great for bank bondholders, to pass it banks needs to hold very high levels of capital, and consequently equity returns in the bank sector are poor. In this case, it is nice to see that the Federal Reserve has the back of the fixed income investor.
Stress Test Unemployment Scenarios
Stress Test Stock Market Scenarios
Source: Federal Reserve