Every year, the top U.S. banks undergo thorough stress tests of their lending portfolios to identify potential risks under stressful economic conditions. These DFAST evaluations are required under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed to mitigate financial crises like the Great Recession.
The stress tests measure how each financial institution would respond to a hypothetical set of economic events. Although all the banks passed this year’s evaluation, the results highlighted that rising credit debt is becoming an alarming risk for banks, especially given that economic conditions are expected to worsen before they improve.
In his report, DFAST in Credit Cards: No Stress Now; Next Year Maybe, Brian Riley, Director of Credit and Co-Head of Payments at Javelin Strategy & Research, analyzed the results of the DFAST assessments and detailed the actions banks can take to prepare for the challenges to come.
The Risk Item
Under the adverse conditions of the DFAST tests, banks would face total credit losses of roughly $684 billion. Consumer credit card losses would amount to $175 billion, the highest among all lending segments. Excluding trading losses, credit cards would account for almost a third of all losses in the simulated economic downturn.
Some of the stressed conditions impacting consumers include housing prices and gross domestic product (GDP). For instance, the stress tests simulated a scenario where housing prices fell over 30%, similar to the decline experienced during the 2008 financial crisis. While GDP also effects consumers, it’s not the central factor in this context.
“In the world of consumer credit, unemployment is the big driver,” Riley said. “When unemployment goes above 10%, as it did in the pandemic and the financial crisis, credit card charge-offs skyrocket. During COVID, some of the best-run banks lost $1 billion per month, and there was nothing they could do. That’s why the stress tests used 10% unemployment as a yardstick, because it represents a realistic worst-case scenario.”
The Top Performer
Not every bank faced the same outcome in the simulation. American Express emerged as the top performer in the credit card industry, exhibiting the lowest charge-off rate under the stressed conditions of the DFAST assessments.
In the simulation, American Express experienced a 10.1% loss of its portfolio, compared to a median loss of 18.6% among its competitors. At the other end of the spectrum was Ally Bank, which would incur a loss of over 40% of its portfolio.
“Credit card charge-offs are the most significant factor in Dodd-Frank stress tests,” Riley said. “Financial institutions must understand the effects of an economic downturn, tighten lending standards, and prepare their operations for delinquency volume before trouble surfaces. It’s essential for banks to spend substantial time in this area operationally. You must have highly trained staff that can negotiate with your customers before charge-offs occur.”
Lending Into a Storm
The DFAST stress tests are built to identify weaknesses in a bank’s lending portfolio and assess their impact on the bank’s liquidity. As last year’s failure of Silicon Valley bank showed, these factors should be top of mind for financial institutions. From operations staff to credit card strategists, every team member should understand three key areas: underwriting, portfolio management, and account controls.
“Credit quality begins at the front end, so the key is underwriting,” Riley said. “This is not the time in the history of the world to start being aggressive with your lending. It must taper down as the economy starts getting worse. You don’t want to lend into a storm unless you can do it strategically, because these issues are lasting longer and going deeper.”
Focusing on underwriting means prioritizing quality over quantity, which includes engaging cardholders with attractive offers while tightening lending criteria to match FICO scores more closely.
Consumers are going to feel stress from economic conditions, which is why it’s critical for banks to build strong customer relationships. However, financial institutions must manage their portfolios more actively in light of rising delinquency volume, which means they must scrutinize new accounts and keep tabs on both active and inactive accounts.
If issues are uncovered, the financial institution should accelerate the collection process to flush out losses sooner.
Getting Ugly
While all the financial institutions passed the DFAST tests this year, the worsening economic environment suggests that the simulated conditions of the stress tests could soon become a reality.
“All the economic indicators point to a tough year next year,” Riley said. “Inflation is still high, and even though interest rates are likely to decrease somewhat, they won’t drop back to where they were a few years ago. Salaries haven’t gone up as quickly as prices have, and all those factors are weighing on consumers. The takeaway is all the banks passed the stress tests this year, but next year it could get ugly.”