Good morning.
In a welcome bit of news for the financial sector, the biggest banks in the U.S. all passed the Federal Reserve Board’s annual stress test. According to the Fed, the 23 banks subject to the test—including giants Citigroup, Bank of America, and JPMorgan Chase—are poised to weather a severe recession while continuing to lend to households and businesses.
All of the banks tested remained above their minimum capital requirements during a hypothetical recession that resulted in projected losses of $541 billion, the results found. In a statement, Michael S. Barr, vice chair for supervision, greeted the results in a measured fashion.
“We should remain humble about how risks can arise and continue our work to ensure that banks are resilient to a range of economic scenarios, market shocks, and other stresses,” said Barr.
His comment suggests it is too soon to predict smooth sailing ahead for the banking sector. For additional insight, I talked with Mark T. Williams, a former Federal Reserve Bank examiner, who’s currently on the finance faculty at Boston University Questrom School of Business. He flagged a lurking danger.
“It’s a positive sign that the big 23 banks passed the stress test,” Williams said. “But this is just a stress test for the macroeconomy. And it wasn't that the stress test gave a clean bill of health. [It] illuminated that commercial real estate risk within these big banks is significant. If we do go into recession, these 23 banks hold 20% of all commercial real estate and that's offices, downtown buildings—that is a looming risk.”
The stress test included a hypothetical situation of a global recession with a 40% decline in commercial real estate prices, a substantial increase in office vacancies, and a 38% decline in house prices. In this scenario, the unemployment rate also rises by 6.4 percentage points to a peak of 10% and economic output declines commensurately.
‘They let that slip a bit in the regulatory oversight’
After the 2008 financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act to prevent excessive risk-taking by banks. Then in 2018, a bill was passed that raised the threshold from $50 billion in assets to $250 billion in assets for when companies qualify as a “systemically important financial institution” requiring the stress testing process.
“A rule called Standardized Liquidity Ratio gets waived for the mid-sized banks, meaning they can hold less liquid capital than for the top tier lenders,” Fortune’s Shawn Tully writes in a recent report. And “Silicon Valley Bank didn’t fulfill the $100 billion mark in average assets until the end of 2021, and therefore wasn’t included in the 2022 test, nor had it ever endured a Fed exam.” And crucially, the Fed’s “severe stress” scenarios completely missed the huge rise in rates, Tully writes.
“I think the Fed has fulfilled its duty with the largest banks, and made sure since 2008, they had been well capitalized,” Williams said. But after the collapse of SVB, Signature Bank, and First Republic Bank, the Fed’s “focus is clearly on the regional and smaller banks because they let that slip a bit in the regulatory oversight,” Williams said.
Due to SVB’s collapse in March, CFOs began facing difficult questions from their boards. During Fortune’s Most Powerful Women Next Gen Summit last month, Dayna Quanbeck, Rothy’s CFO and COO, explained how the company was directly impacted.
“I had diversified cash parked at SVB,” Quanbeck said. “And that was a heartbreaking moment because you think you’re doing the right thing by diversifying and parking cash to keep it safe.”
She continued: "The irony is that we also had safe cash parked at First Republic. So, what you should take away is that I picked the wrong safe banks. But we had our concentration account at JPMorgan.”
“Perhaps CFOs, in particular, are feeling that probably they’re not getting the level of service they had with the regional banks,” Williams said. “So they have to weigh that with the safety of these bigger banks.”
The Fed’s stress test also incorporated market change in interest rates on trading portfolios for the big banks, Williams said. “The banks did fare well,” he said. “It proves that further interest rate shocks, at least in that specific area, won't actually negatively impact the biggest banks.”
U.S. Federal Reserve Chair Jerome Powell said on Thursday in Madrid at the Bank of Spain that interest rates may be raised “two or more times by the end of the year.”
And that won’t be a hypothetical stress test.
In recognition of the July 4 holiday, the next CFO Daily will be in your inbox on Wednesday, July 5. See you next week.
Sheryl Estrada
sheryl.estrada@fortune.com
