Fed Stress Tests Show Banking System Looking Healthy

The Federal Reserve has released the results of its annual stress tests, and our key takeaway is that the banking system remains well capitalized. That means the system has enough capital to handle a severe recession and not only survive but also continue to lend to and support the economy. From a capital perspective, the system is healthy.

At the same time, stress capital buffers, or SCBs, are likely to decline for nearly half the banks we cover that participated in the test this year. This will bring capital relief to some key names, including JPMorgan Chase JPM, Bank of America BAC, M&T Bank MTB, Goldman Sachs GS, and Morgan Stanley MS.

On the other hand, Capital One Financial COF appears set to see the largest increase in its SCB, from 3.1% to 4.8%.

One of the worries heading into this year’s stress tests was that capital requirements would be going up for most banks, becoming another drag on returns and profitability, as well as increasing the odds that a given bank might breach regulatory capital levels. This year’s tests showed the opposite and should provide many banks with a little extra buffer room as they navigate the upcoming changes in regulations.

What Are the Fed Stress Tests?

The goal of the stress tests is to subject the largest banks to severely adverse economic scenarios and simulate what they might do to the banking system. With this information, regulators can better assess whether the system has enough capital to be stable and support the economy, even through a bad recession.

Running this test every year reaffirms to the public that the system is well capitalized and should be resilient through a severe downturn. This type of testing was started after the financial crisis, one of many tools regulators put in place to try to ensure a 2008 kind of collapse would not happen again.

More Regulatory Changes Ahead for Banks

Our big takeaway from this year’s stress tests is that the banks did well and capital levels are fine. However, we are also cognizant that regulatory uncertainty remains. Regulators will likely propose new rules which will result in increased capital requirements. We should get our first look at these proposals soon, potentially within the next few days or weeks. As such, while the banks did well on the tests, higher regulatory requirements are likely coming eventually, and such requirements would probably fall harder on the larger banks.

We emphasize that new regulatory changes will only be implemented after a comment period, with regulators hinting at a rough estimate that new rules would be made official in mid-2024. Even then there are phase-in periods that will likely span several years, giving banks time to adjust.

Looking to the future, we still believe all the banks under our coverage will continue to meet regulatory capital requirements, even through regulation changes (primarily the incorporation of accumulated other comprehensive income, which captures unrealized gains and losses from certain financial transactions, into capital ratios). We expect many of the banks we cover will be in capital-building mode for the time being as they prepare for those changes but will nonetheless meet those future requirements.

Whether management teams will actually lower their internal common equity Tier 1 targets is another story. As they await other potential regulatory changes, we expect most will choose to err on the side of holding more capital rather than less. Even so, we view these banks as the big winners from this year’s stress tests, as the results are set to give them more buffer space for now.