US banks underestimate loan losses in Fed stress test

Systemic lenders predict 34% lower hit to their loan books in latest DFAST exercise

US systemic lenders have continued to lowball simulated loan losses in the Federal Reserve’s stress test, with the gap between their respective estimates widening further.

Under the severely adverse scenario of this year’s Dodd-Frank Act stress test (DFAST), the eight lenders modelled $161.3 billion of aggregate loan losses, $83.6 billion or 34% short of the Fed’s estimate. Last year, the gap was $64.8 billion, or 28%.

 

 

Wells Fargo’s projected losses diverged the most from the Fed’s, at $26.2 billion. Percentage-wise, the gap was biggest at State Street, at 78%.

Bank of America, JP Morgan and Citi undershot loan losses by $18 billion, $15 billion and $13 billion, respectively.

Over the past two years, the gap increased the most at JP Morgan, by 85% to $14.6 billion.

Only two banks managed to converge closer to the Fed-computed figures over the period. At Goldman Sachs, the gap shrank 5% to $4 billion, while at BNY Mellon, it narrowed 58% to just $175 million.

What is it?

The Dodd-Frank Act stress tests, now in their 10th year, subject the largest US banks to a series of economic shocks to test their resilience to a future financial crisis. The 2022 test spans 33 banks, including 10 IHCs. Last year’s tests saw 23 participating banks because the smallest institutions are only required to participate every other year.

This year’s scenario simulated a global recession accompanied by a period of heightened stress in commercial real estate and corporate debt markets. US employment was projected to rise to 10% at its peak in Q3 2023, with markets hit by extreme volatility and commercial real estate asset prices falling by nearly 40%. Abroad, deep recessions were simulated to hit the eurozone, the UK, Asia’s developing countries and Japan, with large swings in the value of those countries’ currencies against the US dollar.

The results of a second round of stress tests, the Comprehensive Capital Analysis and Review, are due to be published following the DFAST. These concern large bank holding companies, and factor in their own capital planning processes. A bank’s CCAR performance dictates whether the Fed will greenlight its planned future capital distributions, making this a closely-watched stress test.

Why it matters

DFAST participants that lowball losses don’t incur penalties. Comparing their projections against the Fed’s, however, provides a litmus test for how aligned their internal models are with regulator-set ones.

Too big a deviation from the Fed’s outputs could mean a bank is overconfident in its books’ ability to withstand a severe recession. It also puts proprietary loss-estimate models under the spotlight, with the risk regulators may deem them not conservative enough. With the future of internal credit risk models in doubt in the US, the divergences in DFAST outputs may provide further food for thought inside the Fed.

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