FED Releases Results of Second Round of Bank Stress Test for 2020

FED released results of the second round of bank stress test for 2020. The results of the December 2020 stress test show that firms maintain strong capital levels under two hypothetical severe scenarios. However, in light of the ongoing economic uncertainty and to preserve the strength of the banking sector, FED is extending the current restrictions on distributions, with modifications. For the first quarter of 2021, both dividends and share repurchases will be limited to an amount based on income over the past year. If a firm does not earn income, it will not be able to pay a dividend or make repurchases. Additionally, the capital requirements of firms will not be reset at this time.

This stress test included two hypothetical scenarios with severe global recessions. The first scenario featured an unemployment rate that spiked to 12.5% and then declined to about 7.5%, while the second scenario included a peak unemployment rate of 11%, followed by a more modest decline to 9%. Under both scenarios, large banks would collectively have more than USD 600 billion in total losses, considerably higher than the first stress test this year. However, their capital ratios would decline from an average starting point of 12.2% to 9.6% in the more severe scenario, which is still well above the 4.5% minimum. Risk-based capital ratios of all would remain above the required minimum. For the December stress test, aggregate losses over the projection horizon at the 33 firms are projected to be USD 629 billion under the severely adverse scenario and USD 612 billion under the alternative severe scenario. For the June stress test, total losses under the severely adverse scenario were USD 550 billion for the same 33 firms.

Earlier this year, FED had conducted its annual stress test and additional analysis in light of the COVID-19 event. Those results found that banks generally had strong levels of capital, but considerable economic uncertainty remained. In response, FED had imposed several restrictions to ensure that banks would preserve capital, including suspending share repurchases and limiting dividends. With the restrictions in place, large banks have recently built capital, despite setting aside about USD 100 billion in loan loss reserves. Loan losses under the December stress test scenarios are higher compared to the June stress test scenario, but are lower than losses under the alternative downside scenarios in the sensitivity analysis, due to the higher severity of those scenarios. Aggregate projected loan losses under the alternative downside scenarios ranged from about USD 560 billion to just over USD 700 billion, compared to USD 514 billion and USD 491 billion under the severely adverse and alternative severe scenarios for the December stress test, respectively.

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