Banks stumble but don't fall in stress test's first round

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WASHINGTON — All 34 banks cleared the first of two supervisory stress tests on Thursday, reporting capital levels well above the required minimum even under a hypothetical severely adverse scenario.

But the test showed that banks face potentially heavy losses in certain loan categories under economic stress, particularly in the area of credit cards, counterparty losses and commercial and industrial lending.

It remains to be seen if those potential pitfalls will impact next week's stress test results, which are more important given the potential for the Fed to reject a bank's proposed capital plan based on the results.

For now, the results of the Dodd-Frank Act Stress Test, or DFAST, concluded that the 34 banks examined in the test would have incurred roughly $493 billion in total losses under the severely adverse scenario, with $383 billion coming from loan portfolio losses and much of the remainder from counterparty losses. But the report said none of the banks had their Tier 1 capital levels fall below the 5% minimum.

“This year’s results show that, even during a severe recession, our large banks would remain well capitalized,” said Fed Gov. Jerome H. Powell, who chairs the central bank's supervisory committee. “This would allow them to lend throughout the economic cycle, and support households and businesses when times are tough.”

DFAST is the first of two supervisory stress tests that the Fed conducts annually on the largest banks it supervises. The test differs from its better-known and more onerous sister stress test, the Comprehensive Capital Analysis and Review program, in a few important ways. Both run a bank’s balance sheet through nine future quarters of hypothetical macroeconomic conditions meant to represent baseline, moderate and severe stress.

While CCAR runs those tests using the banks’ own capital plans, however, DFAST uses a standard capital plan in order to better compare performance of the balance sheets between institutions. There is no supervisory penalty for banks falling below the post-stress capital minimums in DFAST, but no bank has done so since Zions in 2014.

Thursday’s results did show some dramatic losses in certain sectors, though the results don’t take into account the firms’ ability to respond to the economic conditions as they unfold because of the nature of the test. Under the severely adverse scenario, the test estimates roughly $100 billion in aggregate credit card losses and another $100 billion in C&I loan losses, as well as $86 billion in trading and counterparty losses — accounting for more than half of the total write-offs.

Credit card portfolios faced median loss rates of 13.7%, which was considerably higher than the 2016 DFAST results. Federal Reserve officials said part of the uptick in credit card losses can be attributed to the scenario itself, which envisioned substantially higher unemployment than last year’s scenario and that drives up estimates of credit card defaults. But the officials also said part of that result can also be attributed to the increase in the size of banks’ credit card exposures and the higher rates of delinquency than in 2016.

C&I loans typically represent a large portion of losses in DFAST, but the losses were quite high in this year’s DFAST results. The median loss rate across the 34 banks for C&I loans was 6% in the severely adverse scenario, but some banks estimated losses double that rate. Interestingly, C&I losses accounted for $67 billion in aggregate losses under the adverse scenario — a less stringent set of economic stressors — and saw median portfolio losses of 4.3%.

While Dodd-Frank mandates that DFAST be performed on all banks with more than $10 billion in assets, the Fed has taken steps to try to mitigate the impact on smaller and midsize banks. Nevertheless, all U.S. banks with more than $50 billion in assets are subject to a more invasive DFAST process like the one whose results were published Thursday.

That hasn’t stopped midsize banks from complaining about the asset thresholds, and both the House-passed Financial Choice Act and the Treasury’s regulatory blueprint proposing substantial changes to the DFAST regime.

The Fed will publish the results of the CCAR stress test next Wednesday, June 28, at 4:30 p.m.

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