The Federal Reserve Board ("FRB") reported results from the 2020 Dodd-Frank Act stress test (a/k/a "DFAST 2020"). The FRB found that that, despite suffering substantial losses under a "severely adverse" scenario, large banks "could continue lending to businesses and households."
As previously covered, the stress tests involved large banking organizations with assets totaling more than $100 billion. The tests employed a "baseline" scenario using average projections from surveys of economic forecasters, and a "severely adverse" scenario involving a serious global recession in which U.S. unemployment increases to ten percent and the corporate debt markets and commercial real estate experience elevated stress. Banks with large trading operations were required to include a global market shock component in their scenarios, and firms with significant trading or processing operations were required to use a counterparty default scenario component.
Regarding DFAST 2020, the FRB also conducted a sensitivity analysis to examine the ability of large banks to withstand three hypothetical recessions that could result from a COVID-19 event. These scenarios included "a V-shaped recession and recovery; a slower, U-shaped recession and recovery; and a W-shaped double-dip recession."
The FRB found that:
- firms experienced "substantial [aggregate] losses" of approximately $552 billion under the severely adverse scenario, though were still able to continue lending to businesses due to a capital build-up since the 2008 financial crisis;
- for the 18 firms that had stress test results disclosed both in 2019 and in 2020, total losses were substantially similar ($433 billion under the severely adverse scenario in 2020, losses totaling in $410 billion in 2019);
- the increase in losses for DFAST 2020 under the severely adverse scenario is a result, in part, of a "relatively more severe scenario."
Concerning the sensitivity analysis, the FRB identified that loan losses for the banks under the various downside scenarios ranged from $560 billion to $700 billion, and aggregate capital ratios declined from 12.0 percent in the fourth quarter of 2019 to between 7.7 percent and 9.5 percent. The FRB noted that under the U- and W-shaped scenarios," most firms remain well capitalized but several would approach minimum capital levels."
FRB Action
For the third quarter of 2020, the FRB is mandating that large banks preserve capital by (i) suspending share repurchase programs, (ii) capping dividend payments and (iii) permitting dividends to be paid out in accordance with a formula "based on recent income." The FRB is also requiring that large banks "re-assess their capital needs and resubmit their capital plans later this year."
Statements
FRB Vice Chair Randal K. Quarles commented that the results of the stress tests demonstrate the strength of the U.S.'s largest banks in the face of the high level of uncertainty within the U.S. economy. Mr. Quarles emphasized that in response to such uncertainty, the FRB is requiring large banks to resubmit their capital plans to allow the FRB to examine banking conditions more closely.
FRB Governor Lael Brainard stated that stress testing ensures that banks have enough capital to survive severe recessions. In response to criticism that the stress tests' economic scenarios were "excessive and unrealistic," she argued that the shock of the COVID-19 pandemic to unemployment and gross domestic product "far exceeded" the 2020 economic scenario.
Primary Sources
- FRB Press Release: Federal Reserve Board Releases Results of Stress Tests for 2020 and Additional Sensitivity Analyses Conducted in Light of the Coronavirus Event
- FRB Report: Dodd-Frank Act Stress Test 2020 - Supervisory Stress Test Results
- FRB Statement by Vice Chair for Supervision Quarles
- FRB Statement by Governor Brainard
- Assessment of Bank Capital during the Recent Coronavirus Event
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