Major U.S. financial institutions are expected to demonstrate robust capital reserves to withstand potential turbulence in the banking sector, according to analysts, as the Federal Reserve prepares to release the results of its annual stress tests.
While the payouts to investors may see a slight decline, the stress tests play a crucial role in determining banks’ capital planning, including dividend distributions and share buybacks.
These tests are especially significant in light of the recent banking crisis, which witnessed the failure of Silicon Valley Bank and two other lenders.
These institutions faced substantial unrealized losses on their U.S. Treasury bond holdings due to Federal Reserve interest rate hikes, leading to concerns among uninsured depositors. Consequently, market attention will not only be on Wall Street giants like Citigroup, Bank of America, JPMorgan Chase, Goldman Sachs Group, Wells Fargo, and Morgan Stanley, but also on smaller lenders such as Capital One, U.S. Bancorp, and Citizens.
Despite the challenges posed by the toughest stress test in recent years, industry analysts and executives remain confident that the 23 participating banks will exceed the minimum regulatory capital requirements.
Wells Fargo analysts noted that the stress tests provide banks with an opportunity to showcase their resilience under extremely adverse scenarios.
They anticipate that dividends will remain secure, and banks will have excess capital to distribute to shareholders, albeit at a slower pace compared to previous years.
The banking industry has generally performed well in recent times; however, the Federal Reserve has faced criticism for not adequately assessing banks’ vulnerability to rising interest rates in previous tests, as evidenced by the spring bank failures.
In the previous stress test, the Fed projected that banks would incur approximately $612 billion in losses during a severe economic downturn, which would still leave them with capital reserves twice the amount required by regulatory standards.
This year’s stress test poses even greater challenges.
The “severely adverse” scenario developed by the Federal Reserve envisions a 6.5-percentage-point increase in the unemployment rate, compared to 5.8 percentage points in 2022.
The difficulty of the test intensifies as the real economy strengthens, and the actual U.S. unemployment rate is projected to be lower in 2023.
Additionally, the test will assess a 40% decline in commercial real estate prices, a matter of concern due to persistent office vacancies resulting from the pandemic.
The performance of each bank during the stress test determines the size of its “stress capital buffer.”
This buffer represents additional capital required by the Federal Reserve to withstand a hypothetical economic downturn, in addition to the regulatory minimums necessary for daily business operations.
The magnitude of losses incurred during the test directly influences the size of this buffer.
The Bank Policy Institute, a bank lobby group based in Washington, anticipates a slight increase in hypothetical losses for banks this year. It predicts that average capital levels will decline by 3.2% in 2023, slightly higher than the 3% decline observed in 2022.
RBC analysts also expect that hypothetical credit losses will primarily stem from exposure to commercial real estate, potentially necessitating larger buffers for certain banks.
Given the upcoming capital requirements and uncertainties surrounding the economic outlook, analysts suggest that banks will adopt a more cautious approach to payouts this year, leading to slightly lower expectations for capital distribution.
Compared to the previous year, the stress test for 2023 is anticipated to be more comprehensive.
This is due, in part, to the appointment of Michael Barr as the successor to Randal Quarles, who previously oversaw the tests. Barr aims to enhance the dynamic nature of the stress tests by introducing multiple scenarios.
For instance, this year’s test includes an “exploratory market shock” specifically for the eight largest and most complex banks. While this shock will not impact capital requirements, it will serve as a means to evaluate the potential utilization.