US Banks Pass Stress Tests, Opening Door for Buybacks and Dividends

Economic Doomsday Test Passed By 23 Banks

Jul 02, 2023

The Federal Reserve stress test is a hypothetical scenario designed to assess how banks' balance sheets would fare in an economic crash. Essentially they simulate severe economic conditions to evaluate the resilience of banks. This year, banks needed to demonstrate their ability to withstand a 10% rise in unemployment, a 40% plunge in commercial real estate prices, a 38% decline in house prices, and short-term interest rates falling to almost zero. The results showed that the lenders would still have over twice the required capital to absorb these losses. This shows that major U.S. banks could withstand an economic downturn & the news has led to a rise in U.S. bank stocks The stress test also determines how much capital banks must hold and how much cash they can distribute to investors.

Despite fears of a credit crunch, banks are increasing their cash holdings and borrowing capacity to offset possible depositor drawdowns. The Office of the Comptroller of the Currency (OCC) has revealed that banks have strengthened their liquidity positions but must remain on guard for potential challenges.

Stress Test Process

The stress test process involves two main components: the Dodd-Frank Act Stress Test (DFAST) and the Comprehensive Capital Analysis and Review (CCAR). The DFAST is a forward-looking quantitative evaluation of the impact of stressful economic conditions on the capital adequacy of large and complex bank holding companies and U.S. intermediate holding companies of foreign banking organizations. The CCAR, on the other hand, is an annual exercise by the Federal Reserve to ensure that large bank holding companies have robust, forward-looking capital planning processes that account for their unique risks and sufficient capital to continue operations throughout times of economic and financial stress.

Bank Stock Reaction

The S&P 500 Banks index, which is a benchmark for the banking sector, recorded its largest daily percentage gain since June 2, rising by 2.6%. Major banks such as JPMorgan Chase, Wells Fargo, and Bank of America all experienced gains ranging from 2% to 4.5%. Morgan Stanley rose by 1.5%, and Goldman Sachs added 3%. However, Citigroup shares remained flat, as the bank is expected to bolster its capital, which could potentially reduce profits and dividends.

Shares of regional U.S. banks also saw mostly positive movement, with the KBW Regional Banking Index rising by 1.82%. Although the index has recovered by 8% this month, it remains down by 23% year-to-date. The stress test results were seen as positive for regional banks, with portfolio managers noting that regional bank stocks still offer good value and are trading below book value

Banks Tested

The Federal Reserve conducted a comprehensive evaluation of the balance sheets of 23 of the largest lenders in the country. Despite the reassurance these tests provide, they only offer a partial view of the overall banking system. This year, many mid-sized lenders have faced liquidity problems, which raises concerns about the stability of the more than 4,000 smaller banks that were not included in these tests.

Out of the 23 banks tested this year, Deutsche Bank's US subsidiary suffered the biggest capital hit, followed by UBS Americas. Among the banks headquartered in the US, those with businesses more heavily focused on trading, which the Fed classifies as riskier, experienced the most significant declines in capital levels. Despite projected losses of $541 billion, all tested banks would meet minimum capital requirements. These losses primarily stem from loan losses ($424 billion) and trading and counterparty losses ($94 billion). These losses would primarily be in mortgages and credit cards, two areas that are particularly vulnerable during economic downturns.

The passing grades given by the Federal Reserve to banks such as JPMorgan Chase and Goldman Sachs support claims from Wall Street executives and regulators that systemically important banks can withstand heavy losses. Systemically important banks are those whose failure could trigger a financial crisis due to their size, complexity, and interconnectedness with other financial institutions.

Share Buybacks

The passing of the stress tests by the US's largest banks is a positive development for shareholders, as it opens the door for potential buybacks and increased dividends. Banks are now able to publicly confirm their indicative stress-capital buffer and may also reveal potential buyback or dividend plans. Analysts from Wells Fargo estimated that the test results were in line with an estimated 5% growth in dividends by big banks this year, as well as an increase in share buybacks. Payout ratios, which consist of dividends and buybacks, are expected to increase by 13 percentage points to 72% year-over-year at the largest banks to analysts at Keefe, Bruyette & Woods. It is important to note that this increase is primarily a result of lower expected earnings rather than a significant rise in dividends and buybacks. Share buybacks are when a company repurchases its own shares from the marketplace, reducing the number of outstanding shares and increasing the value of remaining shares. Some analysts cautioned against expecting a significant increase in payouts, as the Federal Reserve is set to introduce new capital rules that could lead to higher capital requirements for banks with assets above $100 billion.

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