The Fed Adds Some Stress For Investors In The Largest Banks

This year’s Fed stress test for banks offered one fairly simple takeaway – it’s not the best time to be a money center bank. While super-regionals like Fifth-Third (FITB), PNC (PNC), Truist (TFC), and U.S. Bancorp (USB) had pretty undramatic results and capital market specialists like Goldman Sachs (GS) and Morgan Stanley (MS) came out well, it wasn’t such a smooth process for the largest money center banks like Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JPMorgan (JPM).

The net result of new stress capital buffer requirements is that the largest banks in the country are largely going to be on the sidelines when it comes to significant capital returns to shareholders for the next six to 12 months. While the underlying operating environment is still a good one for banks (loan growth, higher rates, et al) provided that the economy can thread the needle and avoid recession, the lower near-term capital return prospects are going to be another hurdle for these already-pressured shares to surmount.

The Fed Tightens The Screws

There’s always a subjective element to the stress test process, and that will always generate some chatter as to how “fair” the process is, but a basic truth of the process is that regulators insist on a wider capital buffer for large, complex banks – a requirement that I would argue is reasonable given how capital inadequacy at these huge, systemically-important banks can have significant downstream impacts on the banking system and the larger economy (as we all saw during the financial crisis).

Specific to larger banks like B of A, Citi, and JPMorgan, there is meaningful subjectivity when it comes to items like credit losses, trading losses, and earnings power, and the greater amount of cross-jurisdictional claims and Level 3 assets (the most illiquid and hardest to value) at these banks leads to higher capital requirements relative to smaller, simpler peers.

On top of that, there were some new twists in this year’s stress test, including harsher assumptions regarding GDP, credit losses, and potential declines in commercial and residential property values.

The net impact was that the largest banks saw significant increases in their stress capital buffer requirements; roughly 90bp to 100bp for Bank of America, Citi, and JPMorgan, while PNC saw a comparatively light 40bp increase and Truist, U.S. Bancorp, and Wells Fargo (WFC) saw minimal increases.

Higher Capital Requirements = Lower Payouts And Earnings Power

The market had already been counting on higher stress capital buffers for the banking sector as a whole, and while the overall increase was more or less on target with expectations (about 30bp), there was a greater divergence between the low end and the high end, with regional banks and capital market entities seeing lower than expected increases and the money center banks seeing greater increases.

With these higher capital requirements, Bank of America, Citi, and JPMorgan will have to build capital. Bank of America has the least work to do in the near-term, with an implied minimum CET1 ratio of 10.5% for the first half of 2023 versus a Street estimate of 10.4% for Q2’22 CET1. By comparison, Citi is about 60bp deficient (11.4% versus 12%) and JPMorgan about 70bp deficient (11.9% versus 12.6%).

Capital-building will have two primary impacts on these large banks – neither of which is positive for market sentiment. First, higher capital requirements impact the earnings power of banks, essentially requiring a shuffling of the asset mix towards safer, lower-earning assets. Larger banks will likely look to trim back their risk-weighted assets, and particularly those in the trading operations. Although overall bank returns on capital should still be quite healthy in 2022-2024, there will be some modest hit to earnings from these higher capital requirements (likely around 1%-3% over the next 12 months).

Banks that have to build up their capital ratios will also be less generous with capital returns to shareholders. While Goldman announced a 25% dividend hike after the stress test process, with PNC increasing by 20% and Morgan Stanley increasing by 11%, Bank of America announced a much smaller 5% hike and Citi and JPMorgan maintained theirs.

The large banks will also almost certainly be returning less cash to shareholders through buybacks. None of the three (B of A, Citi, or JPMorgan) will likely make meaningful buybacks in the second half of this year against prior Street expectations of $5B, $2B, and $2B, respectively. Moreover, while there’s substantial uncertainty now about what 2023 will look like, it seems entirely reasonable to think that buybacks will be lower in 2023 relative to pre-stress test Street assumptions.

Opportunities For Upside

It’s not all doom and gloom, though. I don’t prize short-term capital returns as highly as the Street, but I can’t argue that they are a meaningful factor in investor expectations and sentiment. While the news for the largest banks from the stress test process wasn’t great, there are still some opportunities for upside.

Loan demand growth was healthy throughout the second quarter of 2022, and with higher interest rates in place and good credit quality trends, banks should be set for attractive profitability. With that, I see it as possible, if not likely, that banks will over-earn expectations, which should free up capital for eventual distribution. In other words, this is “no jam today, but jam tomorrow” sort of situation where total capital returns could prove to be better than feared, albeit on a more stretched timeline.

The Bottom Line

I continue to believe that large banks like Bank of America and JPMorgan offer an attractive long-term return at current prices, but sentiment remains a challenge. Citi is a harder case, as the bank still has a lot to prove with respect to its seemingly never-ending turnaround plans, but that is a situation where a successful turnaround could drive meaningful returns for patient investors. In the meantime, regional banks may be a relatively easier play – they’re exposed to positive trends in loan growth and rates, but have less onerous capital requirements.