How did Goldman Sachs achieve a resounding victory in the Federal Reserve's annual stress test?

According to the Federal Reserve's stress test scenarios this year, Goldman Sachs (GS.US) could incur only $300 million in losses during an economic shock, significantly lower than the $18 billion predicted a year ago. This is also a key reason for the bank's substantial dividend payout to shareholders.

The sharp decline in this forecast reflects Goldman Sachs' efforts in recent years to reduce risk exposure. However, it also highlights technical adjustments in the Federal Reserve's stress testing methodology, which have made it easier for Wall Street's largest banks to pass the tests. As a result, on Tuesday, several banks announced increased dividends and initiated stock buybacks.

Many banks benefited from this more "lenient" testing, but none as significantly as Goldman Sachs. Goldman announced a 33% increase in its quarterly dividend to $4 per share. Due to the expected significant drop in losses, its minimum capital requirement ratio also decreased from 13.6% to 10.9%, the lowest level since the current testing mechanism was implemented in 2020. Barclays analyst Jason Goldberg stated, "Goldman is definitely the biggest winner."

Goldman Sachs and other large U.S. banks are required to undergo the Federal Reserve's stress tests annually to assess their ability to withstand market shocks. This year, the Federal Reserve assumed a 7.8% economic decline within a year, an unemployment rate rise to 10%, a 33% drop in housing prices, and a 30% decline in commercial real estate prices to test the banks' resilience.

A key adjustment in this year's stress test by the Federal Reserve was the exclusion of private equity investments from the market shock scenario, an asset class where Goldman Sachs has a higher direct risk exposure compared to its peers.

Additionally, the Federal Reserve indicated that its models were adjusted to better reflect the gains and losses from market hedging. The Federal Reserve mentioned "atypical client behavior observed at certain banks before the 2024 U.S. elections" as one of the reasons for the improved simulation results for trading losses—this statement is widely believed to also encompass Goldman Sachs.

Betsy Graseck, head of global bank research at Morgan Stanley, stated, "This atypical client behavior, primarily trading activity before the elections, combined with the Federal Reserve's changed assessment of hedging, has indeed been beneficial for the banks."

Nevertheless, Goldman Sachs' simulated trading losses remain far lower than its peers—Morgan Stanley's losses were $7 billion, while JPMorgan's were $10.2 billion. In recent years, Morgan Stanley's capital requirements have been roughly in line with Goldman Sachs, while large deposit-taking banks like JPMorgan and Citigroup typically have lower capital requirements.

For years, major U.S. banks have complained about the opacity of the models used by the Federal Reserve to calculate capital requirements, which often disadvantage them. This dissatisfaction peaked last year, with one of the main banking lobby groups even filing a lawsuit demanding that the Federal Reserve enhance the transparency of the testing process and reduce result volatility.

The Federal Reserve has stated that it is working to improve the transparency of stress tests. However, analysts point out that without more disclosures, it is impossible for outsiders to determine why the disparities among banks are so significant this year RBC analyst Gerard Cassidy pointed out: "Goldman Sachs may have used more hedging derivative strategies than its peers to cope with extreme market conditions — this is precisely what the stress tests assess. Of course, this is entirely possible, but currently, we lack transparency to confirm it."

Stress tests are part of a series of banking regulatory rules introduced after the 2008 financial crisis. The Federal Reserve uses these tests to determine the minimum capital levels banks must hold to cover potential losses. From the banks' perspective, the lower the capital requirements, the greater the operational flexibility. According to Barclays analyst Jason Goldberg's estimates, for every 10 basis points decrease in capital requirements, Goldman Sachs could free up nearly $700 million in capital for business expansion or shareholder returns.

Goldman Sachs CEO David Solomon has been committed to enhancing the robustness of the company's business, which includes gradually reducing the firm's proprietary private equity investments and shifting focus to managing funds for external clients. David Solomon stated on Tuesday that the results of this stress test "reflect the efforts we have made over the years to reduce capital intensity."