Analysis of 2023 CCAR Stress Testing Results

The Federal Reserve released 2023 stress results on 28 June 2023. The results suggest that all 23 banks are well poised to withstand the hypothetical severe recession, where commercial real estate and mortgages fall by 40% and unemployment reaches 10%. It is a common practice in the industry to announce capital actions right after clearing the stress testing exercise. Many banks increased their dividend for Q3 2023. Here are a few key observations from this year's results.

• Most large banks performed well, but Citi did not do as well as it had hoped. Citi's capital requirement is expected to increase marginally by 0.5% starting Oct 2023.
• Banks with significant exposures to mortgages and credit card debt fared poorly. It could be attributed to two factors (a) Fed implemented certain changes to its LGD model and (b) Mortgages and credit cards tend to be more susceptible to the deteriorating economic conditions assumed in this CCAR.
• The projected aggregate losses under the severely adverse scenario for the banking sector amount to $541 billion between 2023:Q1 - 2025:Q2. The majority of these losses are expected from three verticals (i) credit card (ii) commercial real estate (iii) Commercial and Industrial loans C&I.
• A new explanatory shock has been introduced for the first time in the 2023 CCAR cycle. In a typical CCAR scenario, there is an inherent assumption of a flight to quality with diminishing inflation. However, the new exploratory shock assumes a moderate recession accompanies by rising inflation. Arguably, this new shock is intended to overcome a gap in the existing CCAR framework by placing greater stress on banks with significant exposure to negative convexity assets such as MBS. (-ve convexity: These assets will fall more when rates rise, but these do not rise as much when rates fall). However, this shock is mainly introduced on a pilot basis, and it is not used in setting the capital ratios for the banks.

Overall, according to the 2023 stress test results, the bank with the lowest performing CET1 ratio is Citizens, with a minimum CET1 ratio of 6.4%. On the other hand, Charles Schwab emerges as the best-performing bank. Interestingly, both Charles Schwab and State Street exhibit higher CET1 ratios under the severely adverse scenario, possibly due to their specific exposures.

The remainder of this article focuses on the detailed analysis of the stress test results.

Background:

The purpose of stress testing is to assess if Banks can survive a severe recession. While Federal Reserve has been doing these exercises for some time, a new shock (exploratory shock) has been introduced for the first time for the U.S G-SIB banks in the 2023 CCAR cycle. This shock is not used for setting individual capital positions for the banks, instead, it is primarily used for understanding how a bank's capital position responds in an alternate scenario.

How stress testing works:

There are four parts to the Dodd-Frank Stress testing process. First, Federal Reserve provides a range of stress scenarios around February. Then, a set of models are methodologies are chosen for stress testing by the end of the first quarter. Third, Banks submit their data. Finally, using the scenario data and bank-specific data in the stress test models,?Fed projects how banks are likely to fare under the hypothetical scenarios. Consequently, the results are used to set individual capital requirements for participating banks.?

An overview of stress scenarios.

Each CCAR scenario spans 9 quarters between the first quarter of 2023 and the first quarter of 2025. Each scenario is characterized by a set of 28 variables that can be categorized into three groups. Six measures of economic activity, four measures of asset prices, and six measures of interest rates, the remaining variable pertain to international economic conditions. For the purpose of simplicity,?these variables can be understood as growth variables and level variables. The growth variables include GDP, Unemployment, CPI, and treasury yields and level variables such as the stock market index, housing price index, commercial real estate prices, and stock market volatility (VIX). The interest rate variables track government bond yields and corporate bond yields across tenors.?

Severely Adverse scenario:

This is a hypothetical scenario designed to assess the resilience of banks. The main characteristics of the 2023 severely adverse scenario are:

a)??????Unemployment peaks at 10% by 3Q 2024 one year into the scenario

b)?????Inflation falls from 3.25% to 1.25% by the end of the scenario

c)??????Short-term interest falls nearly to 0%

d)?????Asset prices rise sharply ( equity prices fall by 45% by one year and do not return, equity vix reaches 75)

e)?????International variables suggest a recession in the four country blocs: Developing Asia, Europe, the UK, and Japan

o???Overlays:

• Some big banks with over $50 billion in assets are required to stress severely adverse scenarios further by a set of shocks referred to as Global market shocks. To be on the conservative side, the losses from the global market shocks are applied in the first quarter. ?
• Banks with significant trading activity are required to assume the default of the largest counterparty and assess the impact on the capital because of additional losses. This is an additional add-on to the severely adverse scenario.

Base Scenario:

The baseline scenario for the U.S. is tantamount to a consensus forecast of the economic conditions. The key variables are:

a)??????Unemployment rate falls from 3.5% at the end of 2022 to 2% at the end of the scenario.

b)?????CPI inflation softens from 3.25% at the start to 2.25%

c)??????10 Year treasury yields steadily decrease from 4% levels to 3.25% by the end of the scenario.

d)?????House prices increase by 2% per year and commercial real estate prices increase by 3% per year over the scenario

?

What is new?

I believe the exploratory shock has been introduced to plug a gap with the existing CCAR severely adverse scenario.

·????????The global market shock in the current CCAR severely adverse scenario typically assumes a severe recession with fading inflation expectations. I believe a typical CCAR scenario does not cover the risk of increasing interest rates commonly associated with rising inflation, artificially helping banks with exposures that do well in a low-interest rate environment. Thus, the exploratory market shock plugs this gap by assuming a less severe recession with increasing inflation. This increasing inflation scenario assumes significant importance in current conditions where banks like SVB could not cope with the rise in interest rates.

·????????As expected, most banks performed well under the new exploratory shock probably because assets improve with a decline in inflation.

How did Banks fare

All the 23 banks considered in the stress test are able to withstand a severe recession with their capital levels above the stipulated capital requirements (4.5% CET1). The aggregated CET1 ratio is observed to fall from 12% at the start to 10% at the end of nine quarters under the severely adverse scenario. The scenarios assumed stress conditions as worse as a 40% decline in commercial real estate and housing prices. As part of the stress testing framework, Fed assesses individual banks’ revenues, expenses, losses, and capital under severely adverse conditions. Banks fared better in the 2023 stress test exercise relative to 2022 which is seemingly unintuitive. It is partly because inflation was very?high at the start of the CCAR exercise (Q4 2022), and it is expected to come down. Consequently, losses on securities were reduced which offset the higher losses on loans to some extent. The changes in capital ratios can be traced to

a)??????changes in the capital (numerator)

b)?????Changes in RWA (denominator)- But RWA is relatively stable throughout the 9 quarter of CCAR

Drivers of changes in the capital

·????????Net income is the largest component of capital in the CET1 computation. Out of 23 banks, 20 banks registered negative cumulative net income under the severely adverse scenario. Major banks like Bank of America, Capital One, JPM, Citi, and Wells Fargo registered higher aggregate provisions than their revenue. As a result of higher provisions than the pre-provision net revenue, net?income becomes negative.

The key driver for the negative net income is the exponential rise in loan losses and security MTM losses. Losses from loans account for about?80% of the total aggregated losses ($ 541 billion). ?The top three risky verticals in terms of the loss rate are Credit Card portfolio (18%), Commercial and Industrial loans (7%), and Commercial Real Estate?(9%).?

Source: Federal Reserve Stress Test Results 2023

Overall, CCAR results can have significant implications for bank as the amount of capital that they can return to the customer hinges on their performance in the annual stress testing exercise. According to the 2023 stress test results, all 23 banks were able to withstand the hypothetical severely adverse scenario. The bank that performed worst is Citizens with the worst CAR ratio of?6.4% CET1, and the best bank is Charles Schwab.

Note: Views are strictly personal

References: https://www.federalreserve.gov/publications/files/2023-dfast-results-20230628.pdf

Interestingly, Charles Schwab and State Street register a higher CET1 under the severely adverse scenario, perhaps because of their exposures. ?