Fed’s Annual Stress Test shows Improving Capital Ratios at Banks

    On Thursday the Federal Reserve announced the results of its annual stress test on large banks.  The stress tests showed that most large banks would survive a severe recession and crash in the financial markets.  The tests measure how each banks capital levels would be affected by severe disruptions in the economy and the capital markets.  The results of the tests are used by the Fed to dictate how much capital a bank will be allowed to return to shareholders via dividends and share buybacks.  In the Fed’s most adverse scenario, U.S. gross domestic product doesn’t grow or contracts for six consecutive quarters, the unemployment rate peaks at 12.1%, and real disposable income falls for five consecutive quarters, stock prices fall 52 percent, and house prices fall 21 percent.  All of the banks tested by the Fed passed except one, Ally Financial, a bank that is focused on auto lending and one that is still owned by the federal government due to its previous exposure to sub-prime mortgage lending.  The tests did show that banks focused on capital market activity, such as JP Morgan, Goldman Sachs and Morgan Stanley, would be affected by the adverse scenario more than banks focused on consumer lending.  The weaker than average results for investment banks may, in a perverse way, lead to better results for bondholders, as those banks will be limited in their ability to buy back shares, a credit positive.