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Largest U.S. banks clear first round of 'stress tests,' fewer banks tested

The Federal Reserve said Friday that 18 of the largest banks in the United States passed the first round of stress tests, suggesting that some of the biggest names in the financial system should be able to weather a hypothetical recession.

But regulatory changes over the last year resulted in fewer banks being tested. Eighteen of the 35 banks tested last year were required to take the test this year, meaning that smaller firms like BB&T (BBT), SunTrust (STI), and Citizens Financial Group (CFG) were exempt for 2019.

“The results confirm that our financial system remains resilient,” Fed Vice Chairman Randal Quarles said in a statement. “The nation’s largest banks are significantly stronger than before the crisis and would be well-positioned to support the economy even after a severe shock.”

The central bank reported the results as part of its annual Dodd-Frank Act stress test (abbreviated as DFAST), in which regulators require banks to “shock” their balance sheets, income statements, and capital positions to measure their ability to withstand a severe economic shock.

Federal Reserve Vice Chairman for Supervision Randal Quarles addresses the Economic Club of New York in New York City, U.S., October 18, 2018. REUTERS/Brendan McDermid
Federal Reserve Vice Chairman for Supervision Randal Quarles addresses the Economic Club of New York in New York City, U.S., October 18, 2018. REUTERS/Brendan McDermid

Compared to last year’s test, this year’s “severely adverse” scenario involved a steeper downturn in the U.S. economy in which real GDP falls by about 8% compared to its pre-recession peak and in which the 10-year Treasury falls to a trough of about 0.75%. In equities, the Fed required banks to model substantially more volatility, with the U.S. Market Volatility Index (VIX) touching 70%.

Still, banks were able to slightly improve their capital positions in the theoretical shock. Under this year’s test, the 18 banks totaled losses of $410 billion. That figure is a slight decline from the $464 billion that the same 18 firms booked in the 2018 scenario.

Senior Federal Reserve officials said that despite the tougher assumptions in this year’s tests, the banks have improved the quality of assets on their balance sheets.

Compared to the 2018 scenario, most of the 18 banks improved projected loan losses under the hypothetical severe stress. Only three saw increases: Capital One (COF), Deutsche Bank’s U.S. arm, and State Street Corporation (STT). Capital One projected the highest loan losses, at 15.1% of average balances, mostly due to its heavy portfolio of credit cards.

The Fed cautions that comparing the 2018 to 2019 results is tricky because the assumptions are different.

Fewer banks tested

Regulatory changes led to fewer banks being tested.

A bill passed by Congress in 2017 — the Economic Growth, Regulatory Relief, and Consumer Protection Act — provided some exemptions for banks with less than $250 billion in total assets. Those with between $100 billion and $250 billion still have to take the test, but on a biennial frequency.

The most systemic banks are still required to take the test, covering the likes of JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), and Wells Fargo (WFC). The Fed says the firms tested this year covers about 70% of the assets of all U.S.-operating banks.

The DFAST results are unlikely to surprise the street.

“The stress test is yet one more validation that the U.S. banking industry is the most resilient in a generation,” Wells Fargo Securities wrote in a preview note June 19.

Brian Cheung is a reporter covering the banking industry and the intersection of finance and policy for Yahoo Finance. You can follow him on Twitter @bcheungz.

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