In my April letter, I discussed the turmoil in the banking sector resulting from risk management shortcomings that led to failures of several sizable US deposit-taking institutions.
I concluded with the following statement: “if summer arrives without additional failures, I’ll feel comfortable calling “all clear”. Summer has arrived, and I’ll stand by that “all clear” claim.
As part of their regulatory responsibilities, officials at the Federal Reserve conduct an annual stress test for the largest US banks, designed to evaluate the resiliency of the banking system under challenging economic conditions.
The process is similar to an exercise stress test for humans. The regulators’ treadmill for banks include the following assumptions:
- severe global recession
- US unemployment rate rising to 10%
- commercial real estate prices declining by 40%
- house prices declining by 38%
The bank stress test was developed after the global financial crisis and was first applied in 2011. The assumptions are severe. For some time after 2011, large lenders struggled to earn passing grades.
But good news: all twenty-three large US banks that were recently evaluated passed their stress tests. This means balance sheets remain strong enough for the banks to continue to lend to households and businesses for the duration of a downturn.
You can read the details of the test on the Federal Reserve’s website at: Dodd-Frank Act Stress Tests 2023.
Although this news is unlikely to translate to large stock price gains, it does indicate that the financial market plumbing is in good working order and that the bank problems from earlier this year likely have been contained.
RK