Wall street aces its real-life stress test. Every year the biggest U.S. banks endure a tedious exercise, where their businesses are put through a series of theoretical contortions to see how they’d perform in a crisis. One flaw in this plan is that the Federal Reserve, which designs the stress test, has tended to assume that when bad times come, interest rates would fall, not rise. This misconception was corrected by the market, which just staged an exam of its own. Wall Street aced it.
The anxiety was palpable. Financial institutions’ stock prices swung around in March after a year of record-fast rate hikes led to the failure of Silicon Valley Bank and Signature Bank, as well as the voluntary windup of cryptocurrency banking specialist Silvergate Capital. The Refinitiv Financials price return index dropped 16% in 13 days of trading, a magnitude only matched once in the past decade, when Covid-19 first struck. Even now that fears of ricocheting bank runs have subsided, the sector has only regained about half of that decline.
The main learning: The largest lenders weathered the real-life pop quiz without breaking a sweat. Tighter monetary policy demolished the valuation of securities on some smaller balance sheets. But soaring rates have been a boon for mega-banks. Ones that make money from the spread between lending to customers and borrowing from depositors made a mint. While they are passing some of the hikes onto savers, there’s enough left to ensure they are anything but stressed. Interest income at JPMorgan (JPM.N), Bank of America (BAC.N), Citigroup (C.N) and Wells Fargo (WFC.N) increased by more than one-third – a tidy $16 billion in total – making up nearly 60% of their total revenue.
There’s little to raise cortisol levels in Wall Street trading results either. Because their clients also fear sudden shifts in interest rates, they call on fixed-income securities desks to help offlay the risk. Big banks enjoyed revenue that, while more muted than a year earlier when the war in Ukraine sent a jolt through commodity markets, was unusually strong. For Goldman Sachs (GS.N) and JPMorgan, it was the third-best quarter in a decade. At Bank of America, fueled by mortgage trading desks, it was the most lucrative since 2012. Before Covid-19, a good year on Wall Street’s five biggest trading desks netted a collective $75 billion; over the last four quarters, they have generated nearly $110 billion.
An unanswered question is what rising rates will do to borrowers, and the economy more broadly. Office towers, shopping malls, warehouses and other commercial real estate are a worry. Morgan Stanley’s (MS.N) investment bank wrote off $70 million of debt in the last quarter, centered on its holdings of such property. It’s a drop in a bucket that holds $223 billion of loans, but it’s also a reminder that it’s hard to see from the outside where these risks will surface.
Real estate varies widely from one property to the next, and banks are often skimpy with the details. Wells Fargo, with big property exposures, told investors that one-quarter of its commercial real estate loans are for office buildings. It added that its book is diverse with high-caliber backers, but investors essentially have to take that on trust.
If one set of bankers has genuinely faced a stress test, it’s those that arrange to raise capital and structure mergers for clients. Investment banking remains in the doldrums. At the big five, such advisory fees fell 24% to less than half what they were this time two years ago. The drop-off translates into lower earnings, but it has little impact on the rest of the bank. Since those rainmakers are typically paid based on what they produce, their businesses also tend to remain profit centers.
More trials await. One clear outcome of higher interest rates is that banks are lending less, and more carefully. Loans were flat in the first three months at all the biggest banks. Bosses from JPMorgan’s Jamie Dimon to Bank of America’s Brian Moynihan are keen to avoid the impression there will be a “credit crunch,” an understandable concern since a sharp withdrawal of money flowing into the economy would bring into question the very purpose of bending over backward to keep banks safe in the first place. The risk that refinancing gets harder and leads to defaults, however, is real. Fortunately, the Fed does test for a rise in debt gone bad.
Elsewhere, stress may even breed success. Bank of New York Mellon (BK.N), for example, attracted deposits thanks to flight from smaller, less stable peers. JPMorgan, with branches in 48 states and a marketing budget of $4 billion a year, soaked up possibly one-half of all the deposits that moved around the system, according to analysts at Morgan Stanley. And Morgan Stanley itself harvested around $20 billion in wealth management inflows from mid-sized U.S. lenders.
It’s likely the stress tests will be tweaked to include more multidirectional interest-rate shocks. For the big banks, the exam should be a cinch. First-quarter earnings showed they’re sufficiently solid that it takes more than a spike in borrowing costs to rattle them. What the Fed would be wise to do is extend its rigorous exam to smaller banks of SVB and Signature’s size – a category spared such tribulations. While mega-banks may have earned an “A” this time around, their regulator deserves a more middling grade.
Large U.S. banks reported their first-quarter earnings between April 14 and April 19. JPMorgan, Bank of America, Wells Fargo and Citigroup all reported a double-digit percentage rise in revenue, helped by higher interest income, but all of them increased their quarterly charges taken against future bad debt.
Goldman Sachs and Morgan Stanley, which rely less on traditional banking and more on dealmaking and trading, reported respective 5% and 2% declines in revenue from a year earlier. Both said that trading revenue had declined from first quarter 2022, but it was substantially higher than the last three months of the year.
JPMorgan reported a 2% rise in deposits between Dec. 31 and March 31. During that period, two mid-sized U.S. lenders, Silicon Valley Bank and Signature Bank, collapsed, and a third, Silvergate Capital, said it would voluntarily close. Overall, the banking system lost almost 4% of its deposits in the quarter, according to Federal Reserve data.
