Since the 2007-08 financial crisis, all U.S. banks that have been categorized as systemically important have been required to undergo annual stress tests. These tests were detailed under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed after the recession, and have become colloquially known as the DFAST tests.
This objective of the DFAST assessments is to identify significant vulnerabilities in the U.S. financial system before they occur. As Brian Riley, Director of Credit and Co-Head of Payments at Javelin Strategy & Research, detailed in the report DFAST: Tight Credit Card Risk Controls Ensure Bank Liquidity, top banks may not be in any imminent danger, but credit issuers must consider many factors as they forge ahead into next year.
A Catastrophic Cocktail
The DFAST tests measure how each financial institution would respond to a hypothetical economic downturn. In this worst-case scenario, unemployment rises to 10%—as it did during the COVID-19 pandemic—and housing prices fall by roughly a third. Taken with other factors like plummeting equity and real estate values, the DFAST tests create a catastrophic cocktail for financial institutions.
This year’s tests found that these factors would cause more than $500 billion in total credit losses for the top financial institutions. As with last year, consumer credit card losses would be the most impactful among all lending segments, totaling $157 billion. Excluding trading losses, credit cards would account for roughly a third of all projected losses for financial institutions.
Although these numbers were significant, the projected total losses and credit card losses were down from the year before. However, banks aren’t completely out of the woods.
“I think it showed how resilient banks are right now, which is good,” Riley said. “There are a lot of operational improvements, and the charge-offs have been under control, and that’s a good thing.
“The economy is always the risk. Right now, the trend is that it’s going to be better because some of the charge-offs are down, some of the delinquencies are down, but you still have consumer credit at an all-time high—it’s like $1.3 trillion. In the last 10 years, it’s gone up by over $300 billion, so that’s a lot of bananas. You have to be worried about where this is going to level off.”
A Proof Point
This substantial stress on consumers had direct effects on this year’s DFAST tests. Most notably, Ally Financial is no longer included in the index because the company sold its credit card portfolio last year. Ally Financial’s credit risk simulation was the weakest among all credit card issuers, running at a projected 40% loss rate.
Ally built a loan portfolio that catered to borrowers with lower-range credit scores. As a result, Ally was at high risk of default and delinquencies as economic factors pressured consumers in these income brackets.
This was evidenced by last year’s DFAST tests, in which Ally Financial was the poorest performer. The assessment found that Ally would face severe losses under the stressed conditions of DFAST, far more than the 16% to 20% range other lenders experienced.
On the other end of the spectrum, American Express and Chase performed the best in last year’s DFAST tests, and they achieved similar success this year. This is largely because they have cultivated a different customer base from Ally’s.
“The big deal is that American Express and Chase, the two top leaders, are still at the best performance level,” Riley said. “It’s an example showing how American Express uses a lot of discretion when they underwrite. It’s typically FICO scores above 720, and that’s a proof point. Chase is diversified in a lot of ways—they were anchored to the consumer households, and they take advantage of that in their marketing. Those are two good signs of what’s going on.”
Balancing Credit Investments
According to Riley, financial institutions should take a page out of the top lenders’ playbooks and prioritize quality over quantity. One aspect of this model is tightening lending criteria to match borrowers’ FICO scores, but attracting and maintaining a quality customer base is more complex.
Financial institutions should also entice potential cardholders with attractive offers and work to build strong relationships with their customers. Banks also must scrutinize all new accounts and take a closer look at their underwriting processes. Another consideration for lenders is keeping their portfolios balanced to ensure they aren’t over-exposed to one client segment in the event of a downturn.
One of the most important lessons from the DFAST tests is that credit cards play a significant role in the operations of financial institutions and consumer households. Although all of the top-tier institutions passed this year’s assessments, significant risks are in play for smaller issuers.
Credit cards offer high returns for issuers, but they can quickly become a high risk if there is an economic mishap. This means that smaller issuers shouldn’t become overly dependent on their credit card portfolio.
The Party Isn’t Over
Concerns remain about the state of the economy, as inflation and interest rates are still high, and the impacts of tariffs loom. However, if this year’s DFAST tests are any indication, most financial institutions are prepared to weather the storm.
“I think we have to thank our lucky stars that many of the metrics did not deteriorate—that’s important,” Riley said. “There are mixed feelings on why it hasn’t. There’s a lot of talk on interest rates going down right now; they’re relatively high. In Canada, they’re significantly lower. Which one’s better? A lot of it depends on who you ask.
“The takeaway is that things are better, but everybody is walking on eggshells because debt is higher and prices are higher. Even though there are mixed levels of optimism, things do look better in a lot of ways. I wouldn’t say the party’s over because you have indicators like the rising amount of debt.”
