The Fed just released the results of the bank stress test: here’s what you need to know

The Federal Reserve on Thursday released initial results of its annual bank stress tests, which subject bank holding companies through various adverse economic scenarios to see if their regulatory capital can withstand severe hypothetical recessions. The Fed tested 33 banks, each with more than $ 100 billion in assets.

Investors carefully watched this year’s results because the coronavirus pandemic has created real economic scenarios that were unfathomable just a few months ago. Due to the virus, the Fed conducted three more “sensitivity analyzes” to see how a bank’s balance sheet would perform in a V-shaped, U-shaped, and W-shaped recovery.

The results showed that while most banks are reasonably well capitalized, some were uncomfortably close to their required minimum capital threshold in the most severe scenarios. And investors in the sector must understand that some bank dividends may be at risk in the third quarter.

This is what we learned from the Fed report.

Federal Reserve

Image source: Getty Images.

The Fed is restricting dividends

Perhaps the greatest result of the stress tests was the Federal Reserve’s decision to restrict capital distributions, including dividends. Seeing that capital levels in banks can suffer a significant impact as the coronavirus persists, the Fed limited dividends “to the amount paid in the second quarter,” meaning that the dividend is not allowed to rise in the third trimester. In addition, the Fed said it would limit dividend payments to “an amount equal to the company’s average net income for the previous four calendar quarters.”

That means some banks may have to cut their dividends because the past two quarters have generally been characterized by low earnings, or perhaps even losses, potentially limiting the amount that can be paid to shareholders. This does not bode well for a bank like Wells Fargo (NYSE: WFC), which reported just $ 0.01 in earnings per share in the first quarter and is not expected to do much better in the second quarter.

The Fed also suspended the share buyback, though that wasn’t exactly a big surprise considering that banks already suspended them earlier this year and were not expected to resume them in 2020.

A range of results

One of the things the Fed looks at in its annual stress test is the banks’ Tier 1 Common Capital Ratio (CET1). That is the basic level of capital that a bank needs to maintain so that, even after accounting for many unexpected loan losses, it can continue to extend credit to individuals and businesses during a recession.

As previously mentioned, the Fed evaluated banks in three additional severe scenarios this year. These included a V-shaped scenario categorized by a very sudden and severe recession followed by a rapid recovery; a U-shaped scenario that includes a more gradual and prolonged economic slowdown and recovery; and a W-shaped scenario that includes a second round of COVID-19 disruption that begins later this year. These were the assumptions he used behind these scenarios.

Bank Stress Test Economic Assumptions

Image source: Federal Reserve.

As you can see above, the Fed assumed the worst unemployment rate at 19.5% during a V-shaped scenario, and the worst GDP contraction of 13.8% during a U-shaped scenario. The 10-year Treasury fell the most dropped to 0.5% during a W-shaped scenario. This is what happened to the CET1 aggregate ratios of the banks tested in a nine-quarter perspective in these various scenarios.

Stress test results

Image source: Federal Reserve.

After going through these hypothetical scenarios, banks should still be able to maintain a minimum CET1 base ratio of 4.5%. As you can see, banks are largely capitalized well enough to maintain this level in all the various scenarios. But the lowest quartile of banks during a W-shaped recovery is dangerously close to reaching that 4.5% level, which regulators never want to happen. Still, the aggregate CET1 ratio was 7.7% in the W-shaped scenario. However, the Fed’s projections did not incorporate capital distributions, although the Fed noted that common stock distributions during the first half of 2020 they would have depleted aggregate capital ratios by about 0.5%.

Credit losses at banks could worsen greatly

In recent projections made on June 10, the Fed projected that real unemployment would rise to 9.2% and that real GDP would contract 6.5% by the end of 2020. The interesting thing is that it is not so different from the Fed’s severely adverse scenario in their stress tests, where unemployment increases 10% while GDP contracts 8.5%. In this severely adverse scenario, the Fed projected that the weighted average loan loss rate for the 33 banks in a nine-quarter perspective is approximately $ 430 billion.

But in a W-shaped scenario, the nine-quarter weighted average credit loss rate increased to approximately $ 680 billion, or 9.9%, and even more in a U-shaped scenario, with a weighted average loss rate of 10.2% or more loan of $ 700 billion in credit losses. So while things could get worse in their current state, they clearly could get a lot worse, so the Fed is likely to be restricting capital distributions.

Just the beginning

The publication of these initial results is really only the beginning. On Monday, many banks are expected to disclose their capital distribution plans, even if they can keep their current dividends. Furthermore, because conditions are changing so rapidly, the Fed plans to require banks to conduct another round of stress tests with capital plans updated later this year.