Federal Reserve bank stress tests have become an important measure of whether large financial institutions maintain enough capital to withstand severe economic and financial disruptions. For banks, the results can also directly affect decisions about dividends and share buybacks, making the annual exercise significant for both management teams and investors.
Major U.S. banks have strengthened their capital positions since the previous round of testing, providing larger buffers against potential losses. However, tougher hypothetical economic conditions—including a severe global recession, sharply higher unemployment, and negative short-term interest rates—could place additional pressure on bank balance sheets and capital plans.
Banks are better positioned than ever to withstand the Federal Reserve’s annual stress tests. But investors still shouldn’t count on smooth passage.
Sometime this month, the Fed will unveil the latest results of this exercise under which banks have to show how they would contend with myriad challenges including a financial shock and global recession. This is crucial to investors in bank stocks: The tests determine how much banks can pay out in dividends and share buybacks. Around a week after the results are published, the Fed will say whether it has approved or rejected individual bank capital-return plans.
The good news is that lenders have steadily built up capital in the year and a half since the last tests. This gives them substantial buffers to get through the Fed’s adverse scenarios. The six biggest U.S. banks all essentially passed the last round. That said, Bank of America had to resubmit its plan, and others, including J.P. Morgan Chase and Goldman Sachs, had to tweak their capital-return requests.
Since the third quarter of 2014, the starting point for the previous tests, these six banks have grown their common equity Tier 1 capital ratios—the most important measure of balance-sheet strength—by around 1 percentage point, to 12.1% on average. That is a strong position.
The bad news is that the Fed’s risk scenarios are much harsher this time around. Under the most extreme scenario, banks must envision a global recession that drives U.S. unemployment up by 5 percentage points, a bigger jump than in previous tests, to 10%. In a first, the Fed also has asked banks to anticipate what would happen if rates on short-term Treasury notes fell into negative territory.
With much attention being placed on stress tests and capital needs, banks are increasingly mindful of the opportunity costs of creating and retaining capital. For many, a balanced approach that includes increased revenues and retained earnings coupled with increased efficiencies and reduced costs can help meet strategic goals. A focus on channels can be an important component of a larger plan to increase operational efficiencies and profitability, and ultimately, capital.
Strong capital levels provide banks with greater protection against unexpected economic disruptions, but maintaining those reserves also creates strategic challenges. Capital retained to satisfy regulatory requirements or prepare for severe economic scenarios is capital that cannot immediately be returned to shareholders or deployed elsewhere within the institution.
That makes operational efficiency an important consideration alongside capital strength. Banks can improve their financial position not only by increasing revenues and retaining earnings, but also by reducing unnecessary expenses and making existing operations more productive. The combination can help institutions strengthen capital while continuing to pursue broader strategic objectives.
Distribution channels can play an important role in these efforts. As customers increasingly use online, mobile, ATM, and other self-service options for routine banking activities, institutions have opportunities to reconsider how resources are allocated across channels. Improving channel efficiency can reduce operating costs while allowing employees and physical locations to concentrate on services where personal assistance provides greater value.
Ultimately, Federal Reserve bank stress tests highlight the importance of maintaining sufficient capital to withstand difficult economic conditions. Banks that combine strong capital management with revenue growth, cost control, and more efficient delivery channels may be better positioned to satisfy regulatory expectations while maintaining profitability and supporting long-term growth.
Overview by Ed O’Brien, Director, Banking Channels Advisory Service at Mercator Advisory Group
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