The Federal Reserve has completed its third round of stress tests of American banks.  The tests originated in 2009 in the midst of the financial crisis but the most recent round was the first of the annual tests now required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The tests are designed to estimate the outcomes that might be experienced by large banks under extremely adverse economic conditions.  The tests are a tool to help bank supervisors measure whether a bank holds sufficient capital reserves to support its activities under such conditions and the results are not forecasts or expected outcomes. 

Eighteen bank holding companies (BHCs) were subjected to a severely adverse stress scenario which presumed a peak unemployment rate of 12.1 percent, a drop in equity prices of more than 50 percent, a decline in housing prices of more than 20 percent, and a sharp market shock for the largest trading firms.   Over the nine-quarter planning horizon each BHC maintains its pre-test common stock dividend payments and common stock issuance is limited to that associated with expensed employee compensation.

The results suggest that, over the nine quarters, aggregate losses at the BHCs are suggested to be $462 billion including losses across loan portfolios, securities held in the BHCs' investment portfolios, trading and counterparty credit losses from the global market shock, and other losses. 

Projected net revenue before provisions for loan and lease losses (pre-provision net revenue or PPNR) over the nine quarters is $268 billion, which is net of losses related to operational-risk events and mortgage repurchases as well as expenses related to disposition of owned real estate of $101 billion.  Taken together the high projected losses and low projected PPNR results in projected net income before taxes of -$194 billion.

These net income projections resulted in substantial projected declines in regulatory capital ratios for nearly all of the BHCs under the severely adverse scenario.   The aggregate tier 1 common ratio would fall from an actual 11.1 percent in the third quarter of 2012 to a post-stress level of 7.7 percent in the fourth quarter of 2014, including assumed capital actions for the 18 BHCs.

Despite the large hypothetical declines, the aggregate post-stress capital ratio exceeds the actual aggregate tier 1 common ratio for the 18 firms of approximately 5.6 percent at the end of 2008, prior to the first government stress tests conducted in early 2009

"The stress tests are a tool to gauge the resiliency of the financial sector," Federal Reserve Governor Daniel K. Tarullo said. "Significant increases in both the quality and quantity of bank capital during the past four years help ensure that banks can continue to lend to consumers and businesses, even in times of economic difficulty."