The nation’s biggest banks are healthy enough to keep lending in the face of a severe economic shock, the Federal Reserve said on Wednesday as the central bank and other regulators prepare to propose harsher regulations for the financial sector.

Why it matters: The results of the Fed’s annual stress tests — which factor into how much capital banks need to hold — come after a string of bank failures earlier this year took regulators by surprise.

How it works: The Fed started conducting annual stress tests after the 2008 financial crisis.

  • Think of it like a check-up on the health of the financial system: much like a cardiac stress test, the Fed wants to evaluate how well banks would perform under extreme economic scenarios.

Catch up quick: The scenarios include a sharp rise in the unemployment rate, a collapse in residential and commercial real estate prices alongside surging office vacancies and extreme volatility in equity and bond markets.

  • For the first time, the nation’s largest banks were subject to a test of “severe but plausible events” that included a mild recession and higher inflationary pressure.
  • All the banks passed, though some like Wells Fargo, recorded sharper drops than others.

Details: The stress test found that all 23 banks examined remained above the minimum capital levels required by the Fed in a severe, hypothetical recession — despite projected losses of more than $540 billion.

  • Of those losses, roughly $120 billion would stem from credit card losses while another roughly $100 billion come from losses related to commercial real estate and residential mortgages in the economic scenario — both higher than losses projected in last year’s test.
  • In aggregate, bank capital would decline by 2.3 percentage points in this hypothetical scenario, the Fed said. That’s slightly less than the 2.7 percentage point decline in last year’s test, but “comparable to declines projected from the stress test in recent years.”

In Wednesday’s report, the Fed said that “recent events have highlighted the need for humility when assessing large bank resilience.”

  • “Stress tests should continue to evolve over time to reflect an appropriately wide range of risks in today’s complex and interconnected financial system,” the report says.

The intrigue: This year’s test was especially tough, with big shocks created to the commercial real estate sector, which some economists have warned could be the next domino to fall for the financial system as remote work shows staying power.

  • The firms tested this year hold about 20% of all office and downtown commercial real estate loans held by banks.

What they’re saying: “Today’s results confirm that the banking system remains strong and resilient,” Michael Barr, the Fed’s vice chair for supervision, said in a statement.

  • ButBarr added that the stress test is only one way to measure the health of the banking system: “We should remain humble about how risks can arise and continue our work to ensure that banks are resilient to a range of economic scenarios, market shocks, and other stresses.”

What to watch: The Fed is reconsidering the structure of its annual stress tests, particularly after the collapse of Silicon Valley Bank forced extraordinary rescue measures for the financial system.

  • SVB’s bond portfolio lost significant value, a result of the Fed’s aggressive interest rate hiking campaign that sent short-term rates soaring — a scenario rarely incorporated in annual stress tests. Most regional banks, a source of concern for the financial system, were not stress tested this year.

What’s next: Barr is among the regulatory officials leading a proposal that’s widely expected to force banks to hold higher levels of capital — a move that will make the financial system safer, though the industry says it will hurt the economy.