Investors hoping that banks will be more generous with their dividends and buybacks this year may be disappointed by the results of regulatory stress tests, which are due for release on Wednesday.
It's not that the industry is expected to perform badly in the annual exams, which assume catastrophic hypothetical scenarios. Banks have routinely performed well in recent years, and while surprises at individual banks are possible, analysts generally expect the industry to post strong results yet again.
The bigger cloud hanging over the goal of returning more excess capital to shareholders is whether regulators will dial up their requirements through the so-called Basel III endgame. Banks have fought regulators' proposals to increase the amount of capital they're required to hold, and regulators now seem poised to soften their original proposal.
On Monday, Bloomberg News reported that
Still, the outcome of that fight is not yet certain. Analysts say that banks will want to avoid committing to returning too much capital to shareholders in the near term without knowing where the Basel III rule stands.
"Banks are probably going to manage pretty cautiously until they have fuller clarity," said Piper Sandler analyst Scott Siefers, who said the stress tests are just one part of a "larger puzzle."
The Federal Reserve will release the stress-test results at 4:30 p.m. EST on Wednesday. The release will include results from 32 banks with at least $100 billion of assets, each of which will be tested against a hypothetical stress scenario designed by the Fed.
Last year was an "off year" for regional banks, which are
The banks that were tested this year after a break in 2023 are: Ally Financial, American Express, Discover Financial Services, Fifth Third Bancorp, HSBC North America Holdings, Huntington Bancshares, Keycorp, Regions Financial and Santander Holdings USA.
What follows is a rundown of important questions and answers regarding this year's stress tests.
What hypothetical scenario is the Fed testing against this year?
The Fed runs banks' balance sheets through two scenarios: a baseline scenario in which the economy stays on track, and a "severely adverse" one with a major global recession.
In the Fed's worst-case hypothetical, the U.S. unemployment rate hits 10%, gross domestic product declines 8.5% in just over a year before recovering, and inflation moves from 2.8% at the end of 2023 to 1.6% by the start of 2027.
Volatility would spike, the stock market would drop by more than half, and house prices would fall by as much as 36%, according to materials published by the Fed. Property values for commercial real estate — a sector that continues to draw concern from investors and scrutiny from regulators — would fall by 40%.
The downturn would trigger a sharp fall in interest rates, with the benchmark 10-year Treasury yield falling sharply from 4.5% to 0.8% in the span of a few months.
Based on how individual banks fare in the scenarios, the Fed assigns them a stress capital buffer, which is the amount of capital they must maintain on top of the 4.5% minimum capital ratio. This year's stress tests resembled last year's in severity, Siefers said, so it would make sense that stress capital buffers would remain fairly flat.
"Our best guess is the entire group will pass with minimum Common Equity Tier 1 ratios above the implied required minimum," Siefers said. "I think we will all be much more focused on trying to triangulate updated stress capital buffers, meaning capital requirements, which should give us some sense for potential dividend increases, wherewithal to repurchase shares, etc."
The Fed typically requires individual banks to wait several days after the stress test results are published before disclosing their dividend and buyback plans. Some may also wait until they report earnings next month to provide more details.
Still, analysts say there's always a surprise or two in the results that are difficult to predict, since the data that goes into the tests is confidential.
How will bank investors react to the stress tests?
With little advance visibility into the results, it's hard for analysts to predict which banks may get their wrists slapped and face stock-price pressure. It's also difficult to determine which banks may outperform, in which case regulators could allow them to distribute more cash to their shareholders.
There may be "a few unexpected outcomes" with respect to banks' real estate portfolios, particularly at regional banks that weren't part of last year's tests, Bank of America analyst Ebrahim Poonawala wrote in a note to clients.
But banks are coming into the cycle with significant capital cushions on top of their current requirements, giving them an "improved ability to absorb" larger stress capital buffers, Poonawala wrote.
"Surprises from the annual stress test results are inevitable given the inherent opacity, but we expect these to be manageable," he wrote.
Ken Usdin, a Jefferies analyst, said the amount of uncertainty regarding how much the stress tests will impact buybacks and dividends has made it a "comes and goes event."
"I think it's stopped being as much of a make-or-break type of day for investors, and I think it is more of a get-through-the-moment type of situation," Usdin said.
What will we learn about banks' commercial real estate risks?
The stress-test results will help shape investors' view of the industry's health, including whether worries over commercial real estate loans are overdone.
The CRE sector has recently been one of the top areas of concern for analysts and investors, as work-from-home shifts have put pressure on office buildings and multifamily building owners have struggled with higher costs.
Banks with heavy CRE concentrations have seen their stock values slide, even as most lenders' credit-quality reports show resilience.
"It's a pressure point. It's an area in which regulators are appropriately focused," Siefers said. "So we'll certainly be watching there, but I think within the context of overall loss absorption capacity, the group should be able to withstand any losses there."
Some banks are cutting back their exposure to the asset class, which may lead to lower capital requirements, he noted.
Many "generalist" investors have
Nasty surprises at individual banks may feed into the "negative narrative that's out there," said Terry McEvoy, an analyst at Stephens. But the industry performing well under a scenario where CRE prices drop 40% would tamp down those worries.
"We'll have to see what the outcome is," McEvoy said.
Are there additional tests this year?
Several banks with big trading operations — Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo, plus the U.S. divisions of Barclays, Credit Suisse and Deutsche Bank — will be tested against a "global market shock."
In addition, those same nine banks, along with the custody banks State Street and Bank of New York Mellon, will be subject to another test that measures how they would perform if their largest counterparty unexpectedly defaulted.
The results of those tests will factor into the big banks' capital requirements.
A separate "exploratory analysis" that also gauges other risks will not affect required capital levels, nor will investors see bank-by-bank results. The Fed will, however, release aggregate results to give the public a better view of the industry's resiliency to various stresses.
Two of the stresses the Fed will examine will test scenarios where banks' funding costs go up significantly, with banks needing to raise the rates they pay on deposits to keep their funding stable. The other two scenarios would test banks against shocks in financial markets, including the failure of five hedge funds that each bank does the most business with.
