The Federal Reserve recently released the results of its annual stress testing, in which it puts the largest banks in the country through a set of hypothetical severe economic conditions akin to a severe recession.
The goal is to ensure that the nation's banking system is on sound footing. This year, the Fed was not messing around. Between the fourth quarter of 2021 and through the first quarter of 2024, the Fed's hypothetical scenario included unemployment rising above 10%, commercial real estate prices dropping 40%, and stock prices dropping 55%.
All of the banks put through the test passed but still got dinged up. In particular, the Fed calculated that Bank of America (BAC 1.53%), the second-largest bank in the U.S., would incur a hefty pre-tax loss of close to $44 billion over the nine-quarter period in the hypothetical scenario, more than any of the 33 banks tested. So, should investors be worried?
Understanding the scenario
What the Fed is essentially doing is using the economic assumptions in their hypothetical scenario, along with lots of other assumptions, to model out how a bank would perform during the stressed period. One thing to understand is that there are plenty of assumptions the Fed is making that I'm sure bank executives would disagree with in these modeled-out scenarios. Additionally, this is completely hypothetical. The unemployment rate is currently very healthy at 3.6%, and no one expects it to surpass 10% any time soon.
But the reason the Fed does this stems from the Great Recession. Everyone was caught off guard by how ill-prepared banks were, so this exercise is to ensure that the banks are properly capitalized and prepared to deal with an intense recessionary environment.
The Fed's model found that during this nine-quarter period, Bank of America would actually make pre-provision net revenue of more than $28 billion. However, the bank's loss would come from the fact that it would have to provision more than $53 billion for potential loan losses during the nine quarters, which cuts right into the bottom line.
Data source: Federal Reserve.
As you can see, the Fed projects that actual loan losses would total $52.5 billion during the stressed period, including nearly $13 billion from credit card loans and more than $8 billion from commercial real estate.
I thought commercial and industrial loans, which are those made to businesses for things like working capital and capital expenditures, got hit extremely hard, with the Fed projecting that Bank of America would take more than $17 billion of losses in its C&I book.
The other thing to consider is that the loss rate in Bank of America's credit card portfolio in the Fed's scenario is close to 16%. This seems quite harsh, considering that credit card loan losses peaked at about 11% during the Great Recession.
The Fed also modeled out close to $13 billion of trading and counterparty losses during the period, which comes from Bank of America's investment banking division and from holding financial instruments such as derivatives.
In terms of capital, the Fed also looks at how banks' common equity tier 1 (CET1) capital ratio would move under this kind of stress. The CET1 is the main regulatory capital ratio regulators and investors watch and is a measure of a bank's core capital expressed as a percentage of risk-weighted assets such as loans.
Every year, the Fed sets minimum CET1 ratios for banks to maintain, part of which are determined by this stress testing. CET1 capital is used to absorb unexpected loan losses. The Fed found that Bank of America's CET1 ratio would start the stressed period at 10.6% and hit a low of 7.6%, which is still above the very basic CET1 requirement of 4.5% all banks have.
Should investors be worried?
I do want to reiterate that this is all hypothetical. Furthermore, being able to sustain more than $52.5 billion of loan losses and maintain a solid CET1 ratio is good news and means that Bank of America could survive a very severe economic shock.
But as a result of the big hit the bank took during this test, Bank of America will likely see its CET1 ratio requirement increase.
Banks are expected to announce their new projected CET1 requirements and dividend plans on Monday, June 27. A higher CET1 requirement means less excess capital, which is how banks mainly fund dividends and share repurchases, so Bank of America may see its capital return plans slow this year or be much more modest than last year.
