The $153 billion asset Regions Financial (RF -0.42%), based in Alabama, has opted into this year's annual stress testing even though it didn't have to. Each year, the Federal Reserve puts the largest banks with a U.S. presence through a set of hypothetical economic scenarios to make sure they could survive during a severe downturn and still lend to individuals, families, and businesses. While banks with more than $250 billion in assets are subject to stress testing every year, banks with between $100 billion and $250 billion in assets only have to go through stress testing once every two years. And despite going through the Fed's multiple rounds of stress testing last year, Regions has chosen to do it again this year. Here's why.
Stress capital buffer
Stress testing is incredibly important to the large banks each year because it ultimately determines how much capital they will need to hold against their risk-weighted assets, such as loans. Banks would prefer the ability to hold less capital because any capital they have to hold does not earn any kind of return, which ultimately drags down their profitability numbers.
The Fed arrives at the amount of capital a bank will hold by dividing it into three parts. There is the bottom 4.5% requirement that every bank has, then there is the relatively new middle layer called the stress capital buffer (SCB), followed by the top level, which is only for the eight institutions considered to be globally systemically important banks (GSIB). Together, the ratio of total capital a bank holds compared to its total risk-weighted assets is called the common equity tier 1 (CET1) ratio, an important regulatory ratio that investors and regulators watch closely.
Every bank, no matter the size, must reserve capital equivalent to 4.5% of its risk-weighted assets. The SCB is determined by taking the difference between a bank's beginning and minimum required projected CET1 capital ratio during a set period of time under severe global recession conditions that are set by the Fed. Then the Fed adds four quarters of planned dividends as a percentage of risk-weighted assets to arrive at the total SCB, which is floored at 2.5%. So, the lowest that a bank's CET1 ratio can really be is 7% of risk-weighted assets.
Following the Fed's stress testing at the end of last year, the Fed determined that Regions' SCB was 3%. Nearly all of Regions' peers got a 2.5% SCB, and Regions had the highest SCB aside from Citizens Financial Group, which got a 3.4% SCB.
Will Regions get a lower SCB?
Last year, the assumptions behind the Fed's hypothetical economic scenarios were pretty severe. In one severely adverse scenario, unemployment would have peaked at 12.5% at the end of 2021, and then declined to about 7.5%, while gross domestic product (GDP) would have dropped by 3% between the third quarter of 2020 and the fourth quarter of 2021.
In this year's severely adverse hypothetical scenario, U.S. unemployment would rise to 10.75% by the third quarter of 2022, while GDP in that same time period would drop by 4%, with equity prices declining 55%. That's actually more severe on the GDP front, but less so in terms of unemployment. Still, I imagine that if Regions is going through the trouble of stress testing when it doesn't have to, it thinks it has a chance of getting back to the 2.5% SCB.
Now, whether the bank gets a 2.5% or 3% SCB will not change the way Regions manages capital. At the end of the first quarter, Regions had a CET1 ratio of 10.3%, and management said it intends to maintain the CET1 somewhere between 9.25% and 9.75%. If the bank gets its desired 2.5% SCB, its required CET1 ratio would only decline from 7.5% to 7%. But as Regions CFO David Turner said, "There's no way in the world we'd have our spot capital below 7%. I think, as an investor, most investors would have a conniption fit if we did that." Rather, Turner said the new SCB testing is an opportunity to send a message.
When your peers are all under the floor of 2.5% and you're at 3%, it kind of sends this message that your credit quality is worse. We don't believe that and we wanted a very public opportunity to demonstrate that. And that's really what this was all about.
And Regions' credit quality does look solid right now. The bank has reserved enough money to cover losses on 2.44% of its total loan book, but is only expecting to have net charge-offs (debt unlikely to be collected, a good representation of overall losses) of 0.50% of its total loan book. Furthermore, the bank has reduced its exposure to industries significantly impacted by the pandemic down to 4.2% of average loans, and many of its loans in the high-impact industries were performing well at the end of the first quarter.
What will having a lower SCB mean?
As Turner mentioned, having a lower SCB will not really change how the bank manages capital. But it could allow the bank to manage capital to the lower end of its internal range -- closer to 9.25%, which opens up more room for share repurchases, dividends, or acquisitions. But more important, it does send a message to investors that regulators view its credit quality the same way as its peers'. That could put any doubts at ease and continue what has already been a great run for the stock over the last year.