Passing the Test: Is the U.S. Regional Bank Turmoil Subsiding?

Despite recent fears, the top 23 U.S. banks passed the latest supervisory stress tests of the Federal Reserve (the “Fed”), reassuring investors about the safety and soundness of the U.S. banking system.

Introduction

Just a few months ago, the U.S. banking sector seemed to be on the verge of a monumental crisis as severe as the Great Financial Crisis of 2008-2009 (GFC). Three large regional banks failed over a five-day period, followed by the dissolution and sale of First Republic Bank in early May. U.S. financial stocks looked bleak amid surging interest rates and changing consumer habits.^[1]

But the results of the latest Comprehensive Capital Analysis and Review (CCAR) annual health checks presented a more objective view of the robust health of the largest U.S. banks.

What is CCAR?

CCAR is a “stress test” that simulates the effect of distressed economic scenarios on the balance sheet of a bank.

For example, mounting job losses and business failures in a recession would increase loan defaults while real estate and collateral prices decline due to lower demand from strapped consumers and reduced business spending. The bank needs adequate capital to absorb loan losses and avoid insolvency under such a scenario. This is measured by various capital ratios, the amount of capital held by a bank relative to its asset base.

The introduction of CCAR were part of the Dodd-Frank reforms following the GFC.^[2] Regulators sought to ensure that banks—especially those “too big to fail”—would not be at risk of insolvency that requires bailouts with taxpayer money. The tests also determine the amount of capital that banks can return to shareholders in share buybacks and dividends.

The results

Twenty-three of the largest banks and U.S. subsidiaries of foreign banks were tested assuming a severe global recession, unemployment reaching 10% and a 40% decline in commercial real estate values.

On June 28, the Fed announced the results in which all 23 banks had comfortably exceeded the minimum required capital. Ample bank reserves could absorb the total simulated losses of $541 billion in the event of a downturn on par with the GFC.

Aggregate simulated credit card losses of $120 million contributed the most, with consumer-focused banks like Capital One experiencing above-average losses.

Simulated average capital reserves declined from 12.4% to 10.1%—substantially above the minimum threshold of 4.5%. Even the lowest-ranking banks had minimum capital between 6% and 8%.^[3]

The implications

Immediately following the release of the test results, JP Morgan, Morgan Stanley and Wells Fargo announced dividend increases.

However, Michael Barr, Vice Chair for Supervision at the Fed, emphasized the need for humility in the face of uncertain risks following the events of March and May. U.S. officials are finalizing proposals for so-called “Basel III endgame rules,” that should result in higher capital requirements for U.S. banks.^[4] Regulators are wary of the risks to bank stability, especially as liquidity could not be raised in a timely fashion in the runup to March 2023, despite concerns as rates rose quickly.

U.S. bank stocks, including the largest institutions subject to this test and small community banks below $10 billion in assets, are trading well below their historic price-to-earnings (P/Es) in absolute terms and relative to the broad market. The market may remain cautious on bank shares with anticipated new regulations and higher funding costs amid rising interest rates. However, this is a once-in-a-lifetime opportunity to buy banks near all-time low valuations last seen in the early 1990s. Valuation multiples always revert to the mean over time.

TFO offers several solutions that target specific sectors, including U.S. regional and community banks. To learn more about a solution that may be right for you, contact one of our advisors to assist you in your investing journey.

^[1] The Brookings Institution

^[2] Federal Reserve

^[3] Federal Reserve

^[4] FT.com