By Ryan Tracy And Victoria McGrane 

WASHINGTON--The largest U.S. banks are strong enough to keep lending during a severe recession, the Federal Reserve said Thursday, a sign that many banks will soon get permission to return profits to investors by raising dividends or buying back shares.

The Fed's annual "stress test" of banks' financial health found all 31 of the biggest U.S. banks had enough capital to continue lending during a hypothetical economic shock where corporate debt markets deteriorate, unemployment hits 10% and housing and stock prices plunge. The exams are designed to ensure large banks can withstand severe losses during times of market turmoil without a taxpayer bailout.

It was the first time since the tests began in 2009 that all banks had capital levels above what the Fed views as a minimum allowance. The banks will need to maintain those minimum capital levels to pass the second round of stress tests on Wednesday, which will determine whether a firm can return money to shareholders. Two banks, Goldman Sachs Group Inc. and Zions Bancorp, had certain capital ratios that came close to the Fed's minimum, which could limit shareholder payouts.

The overall results buttress regulators' view that the financial system is safer than before the Great Recession, in large part because of loss-absorbing capital built up for the annual stress test exercise. The Fed said the 31 banks' aggregate Tier 1 common capital ratio, which shows high-quality capital as a percentage of risk-weighted assets, dropped as low as 8.2% under the stressful scenario, well above the 5.5% level measured in early 2009 and the 5% level the Fed considers a minimum allowance.

"Higher capital levels at large banks increase the resiliency of our financial system," Federal Reserve Governor Daniel Tarullo said in a statement.

The results could bolster big banks' push to return more of their income to restless shareholders after years of conservative payouts. The Fed will announce on Wednesday whether banks "pass" or "fail" the second round of stress tests and can return their requested amounts of capital to shareholders.

The Fed has loosened its hold on capital payouts somewhat but they are still below precrisis levels. The payments of common-share dividends at U.S.-owned banks in the stress test process rose to $25 billion last year, according to data from Thomson Reuters, from a low of $6.6 billion in 2010, when the banks were most severely constrained. In 2007, those payouts totaled $44 billion. Citigroup, Inc., which failed the tests last year and in 2012, hasn't been permitted to boost its dividend since its 2008 taxpayer bailout.

Changes in the Fed's test this year could limit payouts. Banks with larger capital markets activities--like buying and selling equity and debt instruments--saw relatively higher losses in this year's "severely adverse scenario" due to assumptions of corporate defaults, a greater decline in stock prices, and higher market volatility than in past years, Fed officials said in a briefing with reporters.

Among the biggest banks with large trading operations, Morgan Stanley and Goldman Sachs were some of the worst performers, with Tier 1 common ratios dipping to a minimum of 6.2% and 6.3%, respectively, during the hypothetical scenario.

Fed officials cautioned against drawing any early conclusions about banks' requested shareholder payouts from Thursday's results, which assume banks maintain their existing capital plans rather than including requested changes in 2015 and beyond. In past years, some banks have included plans to raise capital levels alongside dividend requests and other actions that would lower capital levels, they said.

Next week's results will incorporate banks' plans to pay dividends or purchase shares, moves that will likely lower their capital ratios below Thursday's results. That could prove problematic for banks whose capital ratios came close to the Fed's minimum allowance on Thursday, since a payout could further deplete that capital buffer.

Goldman and Zions each had a certain capital ratio within one-tenth of a percent of the Fed's minimum allowance. The Fed looks at five different measurements of capital at each bank, including comparing capital levels against a bank's total assets and against assets weighted by risk.

Banks were told privately by the Fed on Thursday whether their capital plans would put them below the Fed's minimum threshold in next week's tests. Any firm in that situation will have a one-time shot at changing their request for dividends or buybacks. Last year, Bank of America Corp. and Goldman told the Fed they wanted to scale back their payout plans after seeing that their leverage ratio, a measure of equity as a percentage of total assets, had fallen below the Fed's minimum allowance. Both firms would have failed the test without making an adjustment.

But strong capital levels don't guarantee banks will get a green-light to make payouts. As banks have boosted their ability to absorb severe losses, the Fed has increasingly shifted its focus toward banks' culture, governance, and ability to assess internal and external risks. Those "qualitative" factors are now playing a leading role in the Fed's decision about whether to approve or reject banks' requests to pay out billions of dollars in dividends and share buybacks.

Last year the Fed rejected Citigroup, and the U.S. units of HSBC Holdings PLC, Banco Santander SA and Royal Bank of Scotland Group PLC for problems related to their ability to measure and predict risks. The U.S. units of Deutsche Bank AG, which is taking the test for the first time this year, and Santander are expected to fail next week due to "qualitative" factors, according to people familiar with the matter.

The stress tests date to the aftermath of the 2008 crisis, when they were used to shore up confidence in the U.S. financial system. This year's test assessed banks holding about 80% of U.S. banking assets and simulated a substantial weakening in global economic activity, declines in asset prices, and a large increase in financial market volatility. The Fed's "severely adverse" scenario in the U.S. saw unemployment hit 10% in mid-2016, real gross domestic product fall about 4.5% by the end of 2015 and a 25% decline in house prices.

The scenario was generally similar to last year's exams, but reflected regulators' concerns about "leveraged loans" to heavily indebted companies and included deterioration in the credit of large corporations. The Fed also assumed a jump in oil prices to about $110 a barrel--the opposite of what has actually occurred in oil markets since the scenario was released in October. The Fed says the results are meant to test banks' resilience, not predict the future.

By design, the test is harder for the biggest banks. Eight big firms were forced to contemplate the default of their largest trading counterparty, and six big trading firms had to show they could survive a sudden "global market shock."

Thursday's results are supposed to help investors compare banks with one another, since they don't include future changes in banks' capital and dividend plans. Several of the largest banks, including Morgan Stanley and Goldman Sachs, ranked near the bottom in the Fed's side-by-side comparison of bank capital levels over the nine-quarter period of severely adverse economic conditions.

Most firms fared better than they did under last year's test, although about a third fared worse on the Tier 1 common ratio as compared with 2014, including Goldman, State Street Corp. and Wells Fargo & Co.

Zions, which failed last year's stress test for a capital shortfall, had a minimum Tier 1 common ratio of 5.1%, the lowest among all banks. Deutsche Bank's U.S. unit posted the highest, 34.7%, though Fed officials said the test only covered about 15% of its U.S. operations. That will change in the future, when the firm is expected to bring all of its U.S. operations under one holding company to comply with a separate Fed rule.

Among other large banks, J.P. Morgan Chase & Co. had a minimum Tier 1 common ratio of 6.5%, Bank of America Corp. fell as far as 7.1%, Wells Fargo & Co. dropped as low as 7.5%, and Citigroup fell to 8.2%--equal to the overall average.

Write to Ryan Tracy at ryan.tracy@wsj.com and Victoria McGrane at victoria.mcgrane@wsj.com

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