Fed stress tests pass, but are softer: big banks still get a capital green light

The Federal Reserve said all major banks passed its annual stress test, but this year’s test was clearly less severe than in prior years.

The Fed said the 22 banks tested this year would remain solvent under the scenario and above the minimum threshold for continued operation, even after absorbing about $550 billion in hypothetical losses.

In the Fed’s scenario, several downside assumptions were milder than in the 2024 test, including a smaller rise in unemployment, a less severe economic contraction, a smaller drop in commercial real estate prices and a smaller decline in home prices.

These less punishing declines meant smaller simulated damage to bank balance sheets and, accordingly, a lower risk of failure. Since the banks passed the 2024 stress test, markets also expected them to pass in 2025.

Fed Vice Chair for Supervision Michelle Bowman said: “Large banks remain well capitalized and are able to withstand shocks under a range of severe scenarios.” Bowman is the official nominated by President Donald Trump and took on the role earlier this month.

Why this year’s test was less severe: volatility and differences in asset coverage

It is not clear why the Fed chose a less stringent test this year. In a statement, the Fed said past stress test results had shown “unanticipated volatility” and that it plans to seek public and industry input in future years to adjust the test.

The Fed also tested private-equity exposures less aggressively this year, saying such assets are typically held for the long term and are not often sold during periods of market stress.

The Fed did not test any bank’s exposure to private credit. The asset class is roughly $2 trillion in size and has been growing at a worrying pace, according to Fed researchers. The Boston Fed recently said private credit could pose a systemic risk in a severe adverse scenario, which is exactly the kind of risk stress tests are meant to examine.

No language or mechanism for testing or measuring private credit or private debt appeared in the Fed’s news release, report or methodology.

The purpose of stress tests and the key assumptions: commercial real estate, housing, unemployment and stocks

The Fed’s stress tests were created after the 2008 financial crisis to assess whether America’s large banks could withstand a shock similar to the one that occurred nearly 20 years ago in the context of being “too big to fail.”

You can think of the tests as an academic exercise: the Fed simulates a global economic scenario and measures how that scenario would affect bank balance sheets.

The 22 banks tested this year include industry leaders such as JPMorgan, Citi, Bank of America, Morgan Stanley and Goldman Sachs. They hold hundreds of billions of dollars in assets and have business exposure across many parts of the U.S. and global economy.

In this year’s scenario, a severe global recession would drive commercial real estate prices down 30% and home prices down 33%. Unemployment would rise to 10%, and stock prices would fall 50%. By comparison, the 2024 scenario called for a 40% drop in commercial real estate prices, a 55% drop in stocks and a 36% drop in home prices.

What passing means: dividends and buybacks

With a passing grade, these major banks will be allowed to pay dividends to shareholders and buy back stock to return capital. The related dividend plans are expected to be announced next week.