As we previewed earlier, today the Fed would release the latest bank Stress Test results, and as we also cynically expected, every bank would pass and sure enough moments ago the Federal Reserve announced that all banks easily cleared their annual bill of health, acing their annual stress test which found that banks could suffer almost $500 billion in losses and still comfortably meet capital requirements, setting the scene for hundreds of billions in stock buybacks and dividends.
The "test" showed the country’s biggest banks could withstand $474 billion in losses from loans and other positions, and still emerge with more than double the required high-quality common equity tier one, or CET1, capital relative to their risk-weighted assets.
In a statement published by the Federal Reserve Board, the Fed said that the results of the annual bank stress test showed that large banks "continue to have strong capital levels and could continue lending to households and businesses during a severe recession."
"Over the past year, the Federal Reserve has run three stress tests with several different hypothetical recessions and all have confirmed that the banking system is strongly positioned to support the ongoing recovery," said Vice Chair for Supervision Randal K. Quarles.
All 23 large banks tested remained well above their risk-based minimum capital requirements, and as laid out previously by the Board, the additional restrictions put in place during the COVID event will end. As a result, all large banks will be subject to the normal restrictions of the Board's stress capital buffer, or SCB, framework.
The SCB framework was finalized last year and maintains strong capital requirements in the aggregate for large banks with an increase in requirements for the largest and most complex banks. It sets capital requirements via the stress tests, and as a result, banks are required to hold enough capital to survive a severe recession. If a bank does not stay above its capital requirements, which include the SCB, it is subject to automatic restrictions on capital distributions and discretionary bonus payments.
Naturally this is great news, and it means that banks no longer need the Fed's $120BN in monthly QE right?
Joking aside, having aced their tests the six largest US banks - a group that also includes Citigroup, Wells Fargo, Morgan Stanley and Goldman Sachs - will now pay out approximately $142 billion in capital to shareholders, paving the way for them to double total shareholder payouts in the next four quarters, according to data compiled by Bloomberg based on estimates provided by analysts at Barclays Plc.
For those wondering just what the Fed "tested" for, this year's hypothetical scenario includes a "severe" global recession with substantial stress in commercial real estate and corporate debt markets:
- The unemployment rate rises by 4 percentage points to a peak of 10-3/4 percent.
- Gross domestic product falls 4 percent from the fourth quarter of 2020 through the third quarter of 2022.
- And asset prices decline sharply, with a 55 percent decline in equity prices (unclear how many trillions the Fed would have to inject in this scenario to stabilize stonks).
Under that scenario, the Fed calculated that the 23 large banks would collectively lose more than $470 billion, with nearly $160 billion losses from commercial real estate and corporate loans.
Of banks headquartered in the US, investment banking groups Goldman Sachs and Morgan Stanley suffered the biggest hits to their capital ratios in the stress tests, with declines of 5.9 and 4.7 percentage points, respectively. This compared to an average decline of 2.4% points for the 23 banks that underwent the tests, which included the American subsidiaries of foreign banks with significant US operations.
Even in a worst case scenario capital ratios would decline to only 10.6%, still more than double their minimum requirements.
Consumer debt accounted for a smaller portion of overall losses than previous years since most retail customers spent the past year paying down credit cards and other loans during the Covid-19 pandemic. But an increase in expected losses in commercial and industrial loans more than offset that decline. Nearly $160bn of the losses came from commercial real estate and corporate loans.
A summary of how the various bank capital ratios would be impact under the Fed's stress scenarios is shown below.
The Fed also said that, as expected, it would lift pandemic restrictions on bank share buybacks and dividends on June 30th after banks clear stress tests.
The next step is on Monday, June 28: the Fed expects banks to wait until then to analyze the results of the stress tests before announcing any plans for new shareholder payouts, according to senior Fed officials. Then, after the market close, banks can unveil their capital distribution plans. From the tests, the Fed will also prescribe for each bank how much CET1 capital in excess of regulatory minimums they need to keep through a so-called stress capital buffer. The CET1 ratio measured against risk-weighted assets is a crucial benchmark of financial stability.
Barclays analysts estimate the median bank out of the 20 relevant institutions it covers will return over 100 per cent of its earnings to shareholders over the next year, with capital returned to investors approaching $200bn.
In immediate response, the market - which knew the outcome of the test well in advance - bid up bank stocks which rose in postmarket trading, with Bank of America leading the rally among big banks, rising 1.6%; Morgan Stanley +1%, Citigroup +0.9% and Wells Fargo +0.8%, JPMorgan +0.7%, Goldman Sachs +0.6%.
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And while all of the above was exactly as expected, overnight Credit Suisse repo guru Zoltan Poszar warned of a potentially troubling twist.
In his latest Global Money Dispatch, Pozsar notes that among other things, today's stress test results will determine the stress capital buffers (SCB) large banks will have to hold in 2022, which will affect their CET1 minimums. Naturally, lower SCBs allow the largest U.S. banks to run with higher G-SIB surcharges, and this trade-off is particularly important for J.P. Morgan. According to Pozsar, the bank will be more willing to let its G-SIB surcharge climb to 5% this year from 4% last year if its SCB comes in around 2.5%, down from 3.3% currently. As a result, today's release may have "a big impact on the pricing of the year-end turn in FX swaps: if J.P. Morgan’s SCB drops a lot, year-end premia might shrink a lot from here."
There's more: looking ahead to the June 30 expiration of stock buyback limitations, the Hungarian repo guru writes that the upcoming wave of buybacks "destroy balance sheet capacity in the banking system" as banks that return capital to shareholders have less capital to leverage up.
Here's the math: with a 5% Supplemental Liquidity Ratio minimum at the holdco level, banks run 20-times leverage, which means that $10 billion in stock buybacks means $200 billion less of banks’ demand for reserves, Treasuries, MBS, and deposits.
This means that as banks rush to handout cash to shareholders, they will be forced to park even more reserves elsewhere... like for example the Fed's reverse repo facility. This “push” by banks to shed capacity and potentially some deposits will meet the “sucking sound” of the RRP facility in coming weeks. It comes as usage of the Fed's reverse repo facility has been rising by tens of billions daily and on Wednesday just hit a record $813.6 billion.
Now imagine what will happen to the RRP facility if banks indeed proceed to repurchase $142BN in stock; applying Pozsar's 20x leverage multiple, this means that bank balance sheets will shrink by just under $3 trillion, including trillions in reserves which will have to be parked at the Fed, which also means that in the coming weeks usage on the Fed's reserve facility is set to explode to unprecedented levels. This in turn will only accelerate the next funding crisis (now that the banking system has shifted from being asset constrained (deposits flooding in, but nowhere to lend them but to the Fed), to being liability constrained (deposits slipping away and nowhere to replace them but in the money market) thanks to the Fed's IOER/RRP rate hike), as we described in "Powell Just Launched $2 Trillion In "Heat-Seeking Missiles": Zoltan Explains How The Fed Started The Next Repo Crisis."
One final technical consideration from Zoltan is that the flattening of the yield curve in recent days hit bank stocks, so banks may start buybacks on July 1st, which means banks might choose to stay liquid around quarter-end. This will be an extra factor to consider in pricing the June quarter-end turn.
As Pozsar concludes, "ample liquidity is ample only if banks are willing to trade it, and trading liquidity means giving it up, which large banks might not want to do when the “pull” of the o/n RRP facility can complicate re-starting buybacks as early as July 1st."