Fed stress tests US banks for the pandemic era

It is “the most high-profile stress test since the financial crisis”, according to the veteran banks analyst Mike Mayo.

After the close of the trading day on Thursday, the US Federal Reserve will reveal an unprecedented amount of data and commentary on America’s top banks, with potentially far-reaching consequences for the institutions and their shareholders. 

Its trio of announcements includes the annual stress tests showing how the top 34 banks would fare in a hypothetical crash, and another exercise examining whether the top 18 should be allowed to execute their dividend plans. 

The results of those two exercises — launched in the wake of the 2008 crisis — are usually spaced out. This year they will both be on the same day because the Fed is introducing a new way of setting bank capital which has linkages to both exercises.

And, unusually this year, the Fed will also release data on how the top 18 banks as a group would perform in three loosely-sketched pandemic scenarios

Pandemic scenarios 

Markets are skittish because coronavirus cases are on the rise again in the US and KBW analyst Brian Kleinhanzl said the Fed’s “sensitivity analysis” on the pandemic’s possible impact will be the main focus for bank investors.

Fed supervisory boss Randal Quarles sketched out the sensitivity analysis in broad terms last Friday. The Fed ran one scenario with a V-shaped economic recovery, which is essentially the same as the crash scenario in the regular stress tests, as well as a prolonged “U-shaped” recovery and a double dip “W-shaped” outcome. He cautioned that none of these should be taken as forecasts.

Jeff Harte, analyst at Piper Sandler, said that if the scenarios showed something dramatic — such as a doubling in loan losses in the W-shaped recession relative to the V-shaped one, for example, or particularly sharp losses in some categories of loans, if the Fed breaks out the data that way — “investors are certainly going to incorporate it into their forecasts and that’s going to set the market thinking”.

Because the scenarios are so uncertain, the Fed has said it will not publish bank by bank results. Rather, it will give results for the top 18 banks in aggregate. The Fed also said the Covid impacts would inform capital requirements going forward.

Line chart of KBW bank index, points showing US bank stocks are down by a third this year

Dividends, dividends, dividends 

US policymakers, led by Mr Quarles, have gone against the grain in their messaging on dividends, speaking publicly of the importance of continuing payments. European supervisors, by contrast, ordered their banks to halt distributions while economies are ravaged by the pandemic. So far, US banks have only voluntarily suspended share buybacks.

Despite the public pronouncements, there is lingering uncertainty over whether the Fed will use its annual capital planning exercise, known as CCAR, to curb some of the 18 banks’ future payout plans. The Fed has also said it will consider the pandemic’s fallout in its decisions on payout policies.

Tony Scherrer, an investor at Smead Capital who holds shares in Bank of America, JPMorgan Chase and Wells Fargo, said he would be watching for “indications on whether authorities want to get more involved in restricting capital allocation by banks, whether that be buybacks or dividends”. 

He said he expected dividend payments to largely be flat overall this year, and a dividend cut is already factored into Wells Fargo’s share price.

Mr Harte of Piper Sandler said investors should learn what the banks will do for their next quarterly dividend payment or two, but payouts and buybacks further out depend on the new capital requirements. The banks will not present plans based on those requirements until August.

Bar chart of % of profits paid in share buybacks and common dividends for 6 top banks showing Top US banks increased returns to shareholders in recent years

A new era for capital requirements

Banks’ potential losses in the stress scenarios are big news most years, offering granular data on how 34 institutions would perform under specific economic and markets shocks. But the economic shock the Fed conceived in February is in some ways more benign than the reality banks actually face. Today’s unemployment rate of 13.3 per cent is actually higher than the “severely adverse” unemployment rate of 10 per cent banks were tested against.

That limits the stress tests’ usefulness for understanding how banks would withstand unexpected shocks, but the analysis is useful for another purpose: enabling back-of-the-envelope calculations on the new “stress capital buffers” that top up the capital requirements banks will have to reach by October 1.

The Fed says the change to these buffers unifies capital requirements under the stress tests and other analyses and gives banks more certainty, which will help them to plan for things such as dividends.

The central bank has already said capital requirements will increase by about 1 per cent, or $11bn, across the industry but analysts’ forecasts for individual banks’ requirements vary greatly.

Individual banks’ requirements will be communicated to them on Thursday. The Fed has asked the banks not to publish them until at least Monday, although Mr Mayo and Mr Kleinhanzl both said it would be easy for analysts to estimate them based on the Thursday disclosures.

Bar chart of Losses over nine quarters in a 'severely adverse' scenario ($bn) showing Previous stress tests warned of massive loan losses

Whither the Europeans? 

European banks’ US subsidiaries have an ignominious history in the Fed’s annual reviews.

Credit Suisse was the only bank last year whose capital plan did not get a clean bill of health; it earned what regulators called a “conditional non objection”. Deutsche Bank’s main US business got an outright fail in 2018, while its trust bank failed in 2015 and 2016. Santander failed three years in a row, from 2014 to 2016. 

An objection from the Fed can prevent a bank from sending money back to its foreign parent. European banks will also be subject to the new stress capital buffer, which is likely to force them to hold more capital, putting further strain on businesses far from home where profitability is already weak.

Deutsche will be most in the spotlight this year, after supervisors at the New York branch of the Fed told the bank in late March that it was still considered to be in a “troubled condition”, implying extra regulatory scrutiny.

Credit Suisse, meanwhile, must make the case that it has improved its capital planning from last year, when the Fed criticised “weaknesses” and demanded revised proposals.