Today after the close, the Fed will release the results of its latest bank health check when at 430pm the central bank will find that the big six U.S. banks will all pass the stress test with enough capital to withstand economic turmoil, greenlighting continued funding of distributions to shareholders.
According to Bloomberg, one year after the Federal Reserve capped stock buybacks and dividends, the central bank is poised to lift remaining Covid-19 restrictions for banks that perform well on this year’s exams (i.e., all of them) when the results are announced later today, and as a result all six of the biggest US banks - a group that also includes Citigroup, Wells Fargo, Morgan Stanley and Goldman Sachs - are expected to pay out $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.
While the Fed's stress test long ago devolved to a joke, with virtually all banks always passing no matter how draconian the assumptions (apparently nobody at the Fed could possible conceive a global pandemic that would have destroyed the financial system had the Fed not nationalized the bond market and injected $3 trillion in liquidity in 3 months one year ago), the exercise has devolved into nothing more than a calculation of how much of the piles of cash that banks are currently sitting on can be doled out to investors.
“It truly is just a math exercise now,” said Jason Goldberg, an analyst at Barclays. “Given the fact that these banks did really well in the December Covid stress test and generally have more capital today than they did then, they should screen well.”
Well of course they will: after all the Stress Test is also a way for the Fed to pat itself on the back for a job well done, having once again saved the financial system which to this day exists on life support courtesy of trillions in excess reserves that will simply never go away.
Buybacks aside, here is a convenient summary courtesy of Bloomberg what investors are watching for when the Fed announces stress-test results:
The day of the results used to be a frantic affair and banks that survived the exams would quickly announce their plans for distributing capital to investors. But now those plans don’t need the Fed’s sign-off because each bank knows its exact capital minimum. A lender can do whatever it likes with its excess cash. After the results are revealed, the Fed will specify the soonest that banks can announce their latest buyback and dividend intentions. It probably won’t be until next week when firms reveal their plans, though, and banks can choose to do so at a later date as well.
The Fed tested 23 banks in total this time around, a list that includes domestic firms and U.S. subsidiaries of foreign lenders. Banks that pass the annual exam remain subject to a constant requirement that they stay above their capital target for the rest of the year. If a lender falls below at any point, the Fed can initiate enforcement actions before waiting for the next stress test. The stress capital buffer was technically implemented last year; however, because banks were subject to the pandemic-era limitations on shareholder returns, 2021 will be the first year the new system is in full effect.
Some banks have already started sketching out how much cash they plan to return to shareholders as part of the 2021 Comprehensive Capital Analysis and Review - or CCAR - cycle, which includes the next four quarters. Bank of America has said it hopes to raise its dividend and announced plans to repurchase as much as $25 billion of its common stock while JPMorgan’s board has approved $30 billion in stock buybacks over an “indefinite time frame.”
In all, the six biggest U.S. banks are expected to triple their buybacks alone in the coming months to $107 billion.
Previously, banks that were near their regulatory capital minimums or breaching them, may have had to tweak their original payout requests to allay regulators’ concerns. The process is simplified this year and designed to nix this do-over option, known as the mulligan. Bank boards are now allowed to approve the payout plans once the Fed’s calculations are apparent. Bank executives have criticized the process for being onerous and some are pleased the mulligan is gone. “Something I’ve argued for years, let’s not play this game of the mulligan,” Morgan Stanley Chief Executive Officer James Gorman said at an event last week. “This is treating you like you’re grownups. You know what you’re doing. You’re running a prudent business, get on with it, run it the way you should.”
Credit Suisse and Deutsche Bank AG are among the foreign lenders reporting results. Fed Vice Chairman for Supervision Randal Quarles became a target for criticism in recent weeks for his earlier campaign to free Credit Suisse, Deutsche Bank and other foreign lenders from the agency’s most intensive big-bank supervision. He’d argued that such banks have diminishing footprints in the U.S. and don’t need the same level of oversight. But after they were released from the highest level of Fed supervision, Credit Suisse was mired in the Archegos Capital Management scandal and Deutsche Bank is said to be bracing itself for a significant Fed enforcement action tied to years of risk-management failings. “Credit Suisse is one we are watching,” said Alison Williams, an analyst at Bloomberg Intelligence. “The fact that there was some noise around U.S. regulators being unhappy” with Deutsche Bank could potentially raise some risk for the German lender, Williams said.
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While all this is as expected, Credit Suisse repo guru Zoltan Poszar has discovered what may be a peculiar 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."