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The Federal Reserve announced the results of its latest round of banking stress tests on Thursday, saying that the 33 largest financial institutions in the US look safer.
The tests, conducted since 2009 and mandated by the Dodd-Frank Act since 2011, attempt to determine just how safe financial institutions with more than $50 billion in US-based assets are.
The Fed runs a hypothetical test of a recession and severe recession. The severe recession is unique to every year.
“The ‘severely adverse’ scenario features a severe global recession with the domestic unemployment rate rising five percentage points, accompanied by a heightened period of financial stress, and negative yields for short-term U.S. Treasury securities,” said the Fed in its release.
In this scenario, the Fed said that the 33 institutions would lose $385 billion on loans that they have outstanding.
Additionally, the Fed looks at the ratio of capital that the institutions hold against their risky assets, called the Tier 1 common-capital ratio. The lower the ratio, the more worrisome the institutions’ financial situation. The institutions’ ratio stands at 12.3% as of the fourth quarter of 2015. Under the severe-recession scenario, it would be 8.4%. This ratio was just 5.5% at the start of 2009.
In 2015, the Tier 1 ratio stood at 11.9% at the time of the stress test and was estimated to fall to 8.2% in the severe-recession scenario.
For reference, anything above 6% is considered “well-capitalized,” between 4% and 6% is “adequately capitalized,” under 4% is undercapitalized, and under 3% and 2% are considered significantly and critically undercapitalized, respectively. Those firms with undercapitalized rankings or below are not allowed to return cash to shareholders through dividends or buybacks.
“Today’s DFAST results show that capital levels in the industry are high enough to withstand even a very severe scenario of negative interest rates,” said Anna Krayn, senior director at Moody’s Analytics, in reaction to the release.