As the Federal Reserve prepares to release the results of its annual stress tests on Wednesday, major US banks are expected to maintain sufficient capital buffers to deal with a potential economic downturn. However, these banks are likely to be conservative regarding shareholder payouts due to current economic and regulatory uncertainties, according to industry analysts.
Stress tests are designed to assess how much capital lenders will need to survive a severe economic downturn and determine how much they can return to investors through dividends and stock repurchases. This assessment is particularly important after the past year witnessed the failure of three large banks last year, and with the rise in interest rates imposed by the Federal Reserve on regional banks, which particularly affected their portfolios and commercial real estate (CRE) margins. In addition, weak consumer demand is contributing to the cautious outlook on the direction of the economy.
This year, 32 lenders are undergoing stress tests, with Wall Street giants like JPMorgan Chase (NYSE:JPM), Citigroup, Bank of America, Goldman Sachs (NYSE:GS), Wells Fargo and Morgan Stanley facing closer scrutiny. Analysts from Keefe, Bruyette & Woods (KBW) expect that Citigroup (NYSE:C) and Goldman Sachs, along with smaller lender M&T Bank (NYSE:MTB), may show strong performance due to adjustments in the composition of their balance sheets.
Mid-sized lenders, including Citizens, KeyCorp (NYSE:KEY) and Truist, are also expected to draw attention during the tests, as is Discover Financial Services (NYSE:DFS), which has recently faced compliance issues that have increased its status as a target. Potential for acquisition.
A KeyBank spokesperson highlighted the bank's strong capitalization, strong credit quality and diversified funding sources, along with a moderate risk profile. Meanwhile, spokespersons for other banks such as Wells Fargo, Citi, Morgan Stanley, Truist and M&T Bank declined to comment on the results of the upcoming stress test, and others did not respond to inquiries.
The industry has generally performed well in recent years, but the Fed has faced criticism for not adequately assessing lenders' resilience to rising interest rates, as evidenced by bank failures in 2023. Analysts expect all 32 banks to demonstrate capital levels above Regulatory minimum. In the previous year's scenario, the banks tested would have suffered losses of $541 billion in a severe downturn but would still have more than twice the capital required under Federal Reserve regulations.
The 2024 stress test scenario is similar in severity to the 2023 scenario, with an expected increase in the unemployment rate and sharp declines in stock and bond markets, though less severe declines in home prices and the economy overall. A 40% decline in CRE prices was also included, reflecting ongoing concerns about the sector, particularly for regional banks.
Stress tests determine the size of each bank's buffer capital buffer (SCB), an additional layer of capital required by the Fed to cover potential declines in addition to daily operating capital. Analysts from Piper Sandler and KBW note that SCBs are likely to remain stable for most banks, although buffers for Citigroup and Goldman Sachs may decline due to changes in their investment exposure. Conversely, KeyCorp (NYSE:KEY) and Truist Bank may see their buffer reserves increase due to potential impacts on income.
Investors and analysts will be closely monitoring the performance of banks' CRE loans, with regional banks coming under particular scrutiny compared to larger lenders. According to Christopher Wolfe, head of North American bank ratings at Fitch Ratings, banks have booked up to 10% of their office loan portfolios, indicating that central real estate loans will be a major focus in upcoming ratings.
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