Should investors remain steadfast on Stress Test results?

Regulators give the reins back to management

The Federal Reserve’s June 28 approval of the US banks’ payout plans is the first time since the annual tests began in 2011 that all capital plans were approved. Over the next year, the big banks in the USare expected to return close to 100% of expected earnings ($130bn) to shareholders, up from 65% last year.  Another surprise is that the five biggest banks’ payout ratios (averaging 106%) are now above the smaller banks.  Giving shareholders more than 100% of earnings is usually bad for credit.  However, in our view despite the significant increase in shareholder returns, we believe banks will maintain sound credit fundamentals. Specifically, capital and liquidity are expected to plateau at historically high levels while asset quality remains benign, all of which we believe are healthy for the system.

A look at this year’s stress test

This year’s test was slightly more severe than last year’s test with more negative assumptions regarding the unemployment rate in the US, the decline in Commercial Real Estate (CRE) prices, and a more adverse recession in the Euro area and UK. We’ve placed the scenario detail at the end of this article.

On average, all ratios improved year over year and banks finished with 360bps of buffer capital over the 4.5% common equity tier 1 (CET1) stressed minimum in the severely adverse scenario. In other words, under an extreme market event, the US banking system would be expected to have ample capital funding and resources to avoid another ‘Financial Crisis.’ It’s also important to note that the banking system has added more than $750bn in CET1 capital since 2009. A remarkable amount of capital!

Stress test scenarios are ran by the Fed as well as each company itself. We’ve noted those outcomes below. To the extent a bank’s results are significantly different from the Fed’s results, the bank becomes subject to qualitative deficiencies and potentially capital return rejections or reworks (banks have one revision that can be used in the event it is overly aggressive with its original capital plan). 

A comparison of the company-run stress tests versus the Fed’s results

Source: Federal Reserve; company filings. Companies referenced are for illustrative purposes only and do not reflect any recommendation to buy or sell any security.

While overall the big banks performed better under the 2017 test versus the prior year, Bank of America and JP Morgan showed the largest improvements in stressed CET1.  Integrated banks performed better than the brokers and trust banks, with the latter group constrained by their Supplemental Leverage Ratios (SLRs).  Although a couple of banks came close to breaching required SLR levels, recent changes proposed by the Trump administration should make this part of the test easier to pass in the future (details of which can be read in our last article on the CHOICE Act).  Not surprisingly, stress test results for credit card banks were weaker than the others due to consumer credit weakening toward long run averages, which prompted the Fed to include stressed losses in these portfolios that exceeded losses experienced during the global financial crisis. 

Consumer credit remains a segment that we believe warrants more scrutiny and we have been watching credit card loss and delinquency rates steadily ‘normalize’ over the past several quarters.

What next - All good things must come to an end?

Just because bank credit investors have feasted for seven years doesn’t mean we should prepare for famine.  In our view, big bank liquidity, asset quality and capital will remain strong over the coming years.  Returning capital management from the government to bank directors will improve market and bank operating efficiency.  The system will stabilize as returns to providers of debt capital and equity capital will come into balance, and this should benefit all providers of capital.    

Below we’ve provided projected loss results for credit card portfolios, commercial loans and CRE portfolios under the Adverse and Severely Adverse scenarios.

Adverse Scenario:

-          2% decline in US real GDP (from 2016)

-          Equities down 40%

-          House Price Index down 12%

-          CRE down 15%

-          7.25% peak u/e rate

-          Fall in inflation through 3Q17 with CPI rising to 2% by 2H18

-          Drop in short-term rates to near zero

-          10Y UST rises to 2.75% by 2H18

-          10Y UST/IG Corp bond spread widens to 3.75%. while 10Y UST/Mortgage spreads reach 2.5%

Severely Adverse Scenario:

-          Severe global recession

-          6.5% decline in US real GDP

-          Equities drop 50%

-          House Price Index falls 25%

-          CRE falls 35%

-          10% peak u/e rate

-          Inflation falls to 1.25% before peaking at 1.75%

-          Drop in short-term rates to near zero

-          10Y UST drops to 75bps in 1Q17 and graduals rises to 1.75% by 1Q20

-          10Y UST/IG Corp bond spread widens to 5.5%. while 10Y UST/Mortgage spreads reach 3.5%

Losses:

In the severely adverse case, cumulative losses of the 34 Bank holding companies in the test were $493bn vs $525bn (among 33 BHC) last year, broken out as follows:

-          $383bn - loans

-          $86bn - trading

-          $5bn – securities

-          $18bn – other (primarily loans Held For Sale)