The Fed’s 2024 Stress Test: Key Takeaways

Results of the Federal Reserve’s annual bank stress test, released at the end of June, showed that the largest U.S. banks have sufficient capital to withstand a severe economic downturn. But we shouldn’t take the passing grade as a sign that all is clear.

Banks will face considerable challenges in coming quarters as they deal with rising delinquencies and default rates on both their consumer and commercial portfolios. The troubled commercial real estate (CRE) market will drag on earnings for the foreseeable future, under even the best scenario. The interest rate environment and prospects for a slowing economy, moreover, will challenge bank profitability and loan growth – even if a recession is avoided.

Cristian deRitis

Indeed, while there was little doubt that all of the banks subject to the stress test would pass, the Fed’s report highlighted pockets of risk that are growing on banks’ balance sheets.

What are the key findings and takeaways for risk managers – including those at banks not subject to the annual stress test? Let’s dive in

Strong Bank Balance Sheets, but Risk Red Flags Remain

The Fed’s report concluded that the 31 banks subject to the test this year have sufficient capital to absorb nearly $685 billion in losses and continue lending to households and businesses under stressful conditions similar to the global financial crisis (GFC). The severity of this year’s stress test was on par with last year’s, featuring a 36% decline in U.S. home prices, a 40% fall in CRE prices, a 55% drop in equity prices, and an unemployment rate of 10%.

Under this severely adverse scenario, the aggregate common equity tier 1 (CET1) capital ratio of the tested banks was estimated to fall from 12.7 percent in the fourth quarter of 2023 to a projected minimum of 9.9 percent, before rising to 10.4 percent at the end of the forecast horizon in the first quarter of 2026. Even at its lowest point, the CET1 capital ratio of the largest U.S. banks was projected to be more than double the required minimum regulatory level of 4.5 percent, suggesting that the banking system could weather a significant storm without requiring a government bailout or causing a credit crunch.

Despite the passing grade, payouts by banks in the form of share repurchases and dividend hikes are expected to increase only modestly, as bank managers remain cautious. While 2023’s bank failures are in the rearview mirror, banks still face challenges stemming from an inverted yield curve, delayed Federal Reserve rate cuts, deteriorating loan performance, and signs from consumers and businesses alike that the economy is slowing, Moreover, as these headwinds continue to blow, bank earnings and loan growth will remain under pressure in the coming quarters.

CRE: A Complex, Muddied Picture

Given all of the attention CRE has received, including expectations for a “CRE Doom Loop” from a variety of market analysts, it is somewhat surprising that the Fed’s report projects a stable CRE loss rate. But this is not as rosy as it seems.

Although loss mitigation efforts are reducing the acute risk of a CRE market crash, some caution is needed in interpreting the stable loss estimate. Paradoxically, the stability may be a result of all of the attention that the sector has received from bank risk managers and regulators over the past year.

By proactively identifying and managing loans that could be at risk of default as leases expire and mortgages come up for renewal, portfolio managers are mitigating the sharp price declines that would otherwise occur. Thanks to an elongated adjustment process, lenders and markets now have more time to absorb losses and reset price expectations, while limiting knock-on effects to the bank balance sheets and to the broader economy.

What’s more, notably, the number of banks participating in the stress test is larger this year than last year (31 vs. 23). The broader sample may include a set of banks with more conservative CRE portfolios that lower the overall risk profile. Improvement in the outlook for retail and hotel properties may also mask some of the weakness in office and multifamily real estate.

One criticism of the Fed's stress test is that it only focuses on large banks. With smaller regional and community banks holding a greater concentration of CRE loans on their portfolios relative to large banks, the stress test results may not fully reflect the risk that CRE loan portfolios could pose to the broader financial system if defaults were to accelerate quickly. An increase in the number of small and mid-size bank failures could undermine confidence and precipitate capital flight, even if the overall banking system remains financially sound.

Lending backed by commercial office buildings is particularly vulnerable, as $929 billion of the $4.7 trillion of outstanding commercial mortgages held by lenders and investors will come due in 2024, according to the Mortgage Bankers Association. Given declining property values, higher vacancy rates, and lower rent growth, lenders will face significant challenges in managing the pace of loan modifications and foreclosures for these assets.

New Exploratory Scenarios Address Emerging Risks

New to this year’s stress test was an exploratory analysis, including two funding stress scenarios applied to all banks tested and two trading book stresses applied only to the eight largest and most complex banks – otherwise known as global systemically important banks (G-SIBs). This exploratory analysis was distinct from the stress test used to assess capital adequacy. Rather, the intent was to explore additional hypothetical risks to the broader banking system.

The two funding stress scenarios included a rapid repricing of deposits, combined with both a severe and moderate recession. The Fed’s analysis found that large banks experiencing these scenarios would remain above minimum capital requirements in aggregate, with capital ratio declines of 2.7 percentage points and 1.1 percentage points, respectively.

Under the two trading book stresses, which included the failure of five large hedge funds under different market conditions, the largest and most complex banks were projected to lose between 1.0 and 1.2 percent of their risk-weighted assets. While banks do have material exposure to hedge funds, the test showed that they can withstand a variety of trading book shocks.

Regulatory Uncertainty

In addition to future earnings uncertainty, banks subjected to the Fed’s stress test may be reluctant to increase their total payouts due to potential regulatory changes on the horizon. Although the strength of bank balance sheets demonstrated in the stress test results may justify an easing of the increased capital requirements being proposed by the Basel III Endgame rules, some policymakers may take a different view, given the portfolio-level risks highlighted in the report.

Furthermore, the 2023 failures of Silicon Valley Bank, Signature Bank and First Republic Bank may lead to the conclusion that more regulatory oversight and capital is needed, considering that prior years’ stress tests did not throw up any warning signs. The most likely outcome is a middle of the road compromise, with regulators adopting a single digit percentage increase in capital standards going forward, instead of the 16% increase initially proposed.

Parting Thoughts

The Federal Reserve’s stress test should give policymakers, shareholders and the general public a sense of comfort that banks could weather a very nasty economic storm. Banks, in short, would not face the same existential crisis they did back in 2008 if there were a repeat of the GFC.

However, digging below the surface, the Federal Reserve’s report highlighted several areas of concern. For example, it projects higher loss rates for corporate credit portfolios, consistent with banks downgrading the quality of the loans on their books. It also predicts higher credit card losses in 2023, because of increases in banks’ credit card balances and rising delinquency rates.

Moreover, the CRE market remains bedeviled by declining property values, higher vacancy rates, and lower rent growth, and banks’ profitability and loan growth are now facing an uphill battle against a slowing economy.

These issues notwithstanding, the Fed’s annual stress test continues to deliver value to regulators, shareholders and the general public. Although the test is far from perfect and the models used need to be continuously refreshed and updated to address emerging threats, the exercise forces institutions to think carefully about their portfolio strategies and provides depositors and investors with confidence-building transparency.

Risk managers would be wise to continue to enhance and leverage their stress testing infrastructure to conduct their own threat analysis for strategic planning and portfolio optimization.

Cristian deRitis is Managing Director and Deputy Chief Economist at Moody's Analytics. As the head of econometric model research and development, he specializes in the analysis of current and future economic conditions, scenario design, consumer credit markets and housing. In addition to his published research, Cristian is a co-host on the popular Inside Economics Podcast. He can be reached at cristian.deritis@moodys.com.