We published a report in April this year analysing dilution risk in equities from the economic downturn triggered by the lockdown related to the COVID-19 pandemic. Because of the uncertainties that existed about the depth and duration of the economic crisis, the report focused on two scenarios for assessing the risks that investors faced. In this report, we look at those scenarios using the results of the Federal Reserve’s (Fed) 2020 stress test of US banks.
In addition to its regular stress test, the Fed has also performed a sensitivity analysis this time to assess the vulnerability of the US banks in three different economic recovery scenarios (V-, U-, and W-shaped). This analysis demonstrates that the path the economy takes in its recovery matters more than the economic shock itself. Loan losses are most severe under the Fed’s U-shaped scenario. Should losses under this scenario materialise, our analysis suggests the Tier 1 (core) capital ratio of the US banks could fall to 8.1%, five percentage points below its 2019 level, but still above the acceptable minimum capital limit . A cautious approach to managing banks’ capital is required but, unlike the 2008 financial crisis, banks are unlikely to be forced into raising much additional capital this time.
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