Don't Expect Many Surprises From Fed Stress Tests, But Other Capital Changes Are Likely Coming

Investors are once again about to get a look at the results of the annual ritual that is the balance sheet stress tests required by the Dodd-Frank Act (also called the Dodd-Frank Act Stress Test, or D-FAST). This process stress tests the balance sheets of the largest U.S banks against a variety of economic scenarios established by the Fed, with the goal being to ensure that the largest banks have adequate capital reserves to withstand economic downturns.

In practice, this process largely informs the amount of capital these banks can return to shareholders as well as the near-term profitability of the banks - the more capital a bank is required to hold, the lower the earning potential of the bank and the less surplus capital that can be returned to shareholders.

While the annual test results usually provide a surprise or two, those surprises are generally modest in nature and typically result in a bank or two having to increase their Common Equity Tier 1 capital (or CET1) ratio and pull back on dividend payouts and/or share buybacks, while a few banks end up in a position to return more capital than expected.

I expect this year to be a little different. I believe the largest banks have learned how to navigate this process more smoothly, and I expect fewer surprises despite a harsher adverse scenario in the test. The bigger changes for banks are likely to come later, as the Fed contemplates new rules tied to Basel III "Endgame" (also called "Basel IV") and new rules in the wake of the failure of Silicon Valley Bank and First Republic and the severe liquidity and duration mismatch-driven confidence crisis that hit regional banks. These later changes could prove the most impactful, with meaningful changes to the operating performance of banks like Goldman Sachs (GS), Bank of America (BAC), Regions (RF), and many others.

D-FAST - Big Shifts Seem Unlikely

Given that many large banks were already building up capital in response to 2022 D-FAST results and management expectations for a weakening economy in 2023, I don't believe this next round of stress test results (to be released after market close on June 28) are likely to be as impactful to bank financial models or investor sentiment.

To start off, the D-FAST process only includes the largest banks in the country, with larger regionals (including Fifth Third (FITB), KeyCorp (KEY), and Regions only included every other year. Other smaller regional banks are excluded. What's more, the recent investor confidence crisis was driven by liquidity (inadequate deposit coverage and unrealized losses in bond portfolios), not credit risk, and the D-FAST process is largely focused on the credit risk side.

We already know the assumptions that are being used for the "severely adverse" scenario. Under this scenario there is a severe global recession that includes significant declines in real estate prices (housing down 38%, commercial real estate down 40%), a real GDP decline of 8.75% from Q4'22 to Q1'24 (and a peak annualized quarterly decline of 12% versus 6% in last year's test), and near-zero rates.

There will also be a new "exploratory market shock" component that will only be applied to a handful of institutions (Bank of America, Bank of New York Mellon (BK), Citigroup (C), Goldman, JPMorgan (JPM), Morgan Stanley (MS), State Street (STT), and Wells Fargo (WFC)) that will include a less severe recession but higher inflation (a sharp increase in short-term rates, a stronger dollar, higher credit spreads, and higher commodity prices), but this will not impact capital requirements this time around.

Given that banks have already been factoring in more conservatism in their capital requirements, I don't expect many large surprises here, and I think the overall increase in CET1 ratios will likely be something in the neighborhood of 0.25%, with a larger potential impact (something like 0.5% to 0.6%) to non-GSIBs (the smaller banks in the group). M&T Bank (MTB) could see a squeeze given its larger leverage to CRE lending, and Citi and Bank of America could see a little squeeze as well (as they currently are closer to the computed minimum), but I don't think there will be large changes across the board.

D-FAST Is Only The Appetizer

While I expect D-FAST results to be taken in stride by the Street, there are more significant changes on the horizon that could have a much bigger impact on capital requirements, bank profitability, and the overall health of the economy. These are the Fed's new rules around the implementation of Basel IV and whatever new rules may be imposed in the wake of the failures of SVB, Signature, and First Republic.

Basel IV

How the Fed implements new Basel calculations and capital requirements could have a major impact on the banking sector and U.S. economy, with the possibility of a 10% to 20% increase in capital requirements. That, in turn, will lead to higher credit costs for borrowers and will likely push more lending to non-regulated non-bank companies.

The two biggest elements of the Basel IV reforms to monitor are changes to the measurement of operating risk and the calculation of risk-weighted assets (or RWAs), including the "Fundamental Review of Trading Book" (or FTRB).

The new Basel requirements include a calculation of operating risk in the standard RWA methodology (replacing the Advanced Measurement Approach). This calculation is meant to measure the risk of loss coming from inadequate internal controls/systems and external events (including legal risks). At the risk of oversimplification, this calculation factors in interest, lease, and dividend income (or ILDC), services income (service charges, et al), and financial income (trading, investment banking, and insurance income), and then multiplies them by an internal loss multiplier (or ILM), a scaling factor meant to basically discount riskier/more volatile sources of income.

The net impact is this - the system significantly favors income from "traditional" banking (net interest income) and punishes non-interest income to varying degrees. It's most punitive toward trading and i-banking, and less punitive towards insurance and payments-based revenue, but those are still less favorable under this system than net interest income. This will have a big impact on banks like BNY Mellon, Goldman, and Morgan Stanley (banks with relatively less traditional lending), as well as a potentially meaningful impact on banks like Bank of America and JPMorgan (large trading desks and i-banks), and at least some impact on banks like Truist and U.S. Bancorp (large insurance and payments businesses, respectively).

Turning to FTRB, and again risking oversimplification, this new approach will lead to stricter/more conservative potential loss assumptions and it will take away some of the discretion banks have in distinguishing between investments "held for investment" and "available for sale", and that could be a risk for banks like Truist and U.S. Bancorp that have sizable securities portfolios.

A key unknown in this process is how the Fed will account for "double-counting" and the sort of phase-in period they will offer. At least some of the risks included in the new operating risk calculation are already captured by the D-FAST methodology (namely the G-SIB surcharge), so the impact to the capital requirements of those banks with large surcharges today could be relatively modest compared to banks like Northern Trust (NTRS), Regions, Truist, and U.S. Bancorp.

While capital buffer requirements will almost certainly head higher, the Fed needs to be careful about overcorrecting. Increasing the capital requirements will effectively increase the cost of capital, having a similar near-term effect as higher rates (slowing the economy), but it will also likely drive more lending to non-bank entities (in CRE, for instance, insurance companies and hedge funds are already significant credit providers). Thus, there's a needle to thread here with respect to ensuring the capital adequacy of banks without inadvertently driving even more borrowers toward unregulated, harder-to-monitor sources of funding.

Post-Crisis Changes

How the Fed implements Basel IV is a big unknown (a proposal for new rules should come in mid-July), but so too is how the Fed will ultimately react to the liquidity issues and confidence crisis that sunk banks like First Republic, Signature, and Silicon Valley Bank.

Including banks like SVB in the D-FAST process wouldn't have done much to prevent the issues that sunk those banks (namely, an over-aggressive approach toward liquidity and duration management), and I likewise don't see the new Basel IV rules as addressing those principal factors.

I honestly don't know how the Fed will approach this, but regulators around the world have a history of safeguarding against the last crisis - D-FAST came after the Global Financial Crisis and addressed credit risk management, and I expect the next phase of regulation will look more at liquidity and duration management. To that end, I would expect these new rules to target liquidity and duration, likely effectively requiring banks to operate with lower loan/deposit ratios, more secure funding sources, and with more stringent mark-to-market rules.

These changes wouldn't likely affect the largest banks all that much, but depending upon how far the Fed extends new rules (to regional banks, and possibly community banks), it could significantly alter the business models for faster-growing, more aggressive banks that have historically operated with higher loan/deposit ratios and more reliance on non-core deposits (uninsured deposits and/or brokered/wholesale funding). That will make these banks less profitable, and it will also increase borrowing costs (most especially in areas like small-scale CRE).

The Outlook

At this point I believe most bank models factor in what I expect will be modest increases in CET1 requirements from the D-FAST process - again, a surprise or two is likely, but I think the market largely has this dialed in. The bigger unknowns are tied to Basel IV implementation and new post-SVB rules. Those changes could meaningfully impact the profitability of regional banks like Fifth Third, Key, M&T, Regions, Truist, and U.S. Bancorp, and I believe that uncertainty is likely to weigh on bank stocks a while longer.

The Bottom Line

At this point I continue to see value in well-run giant banks like JPMorgan (which I believe is among the best-run banks in the world). I also see value in many regional banks, including M&T and Truist, but that value is offset by what I expect will be a cautious view from the Street until more of these unknowns are resolved.