As expected, 23 of the largest banks with a presence in the U.S. easily passed the Federal Reserve's 2021 annual stress testing, the third such time within roughly the last year that banks have been put through the exercise.

As a result, limitations on bank capital distributions that have been in place for most of the pandemic will expire on June 30 and banks will get the green light to repurchase shares and grow their dividends much more autonomously, although still subject to normal limitations.

Let's go through what happened in stress testing and what this could mean for some of the largest bank stocks.

Annual stress testing

Stress testing was born from the 2007-09 Great Recession and the Dodd-Frank legislation that followed in 2010 to try and ensure that banks would never cause a financial collapse again. Stress testing is also done to ensure that banks are adequately capitalized so they can endure the shock from a severe recession and still have the ability to lend to individuals, families, and businesses during those difficult financial times.

A watering pot releasing coins into a flower pot with coins and money growing from it.

Image source: Getty Images.

During stress testing, the Fed puts banks with more than $250 billion in assets through a series of hypothetical economic conditions to see how their balance sheets and capital levels would fare during a severe downturn. Banks having between $100 billion to $250 billion in assets only have to go through stress testing every other year, although they can choose to opt-in during an off year.

In 2020, due to the economic uncertainty from the pandemic, the Fed tested banks twice and put them through some very harsh scenarios, to which banks still managed to stay above their minimum capital requirements. That's why, with the economy on the mend, there was very little chance that banks would not pass this round of stress testing.

This year's severely adverse scenario dreamed up by the Fed looked at operations from Q4 2020 through Q3 2022 and said unemployment would rise 4% and peak at 10.75%, gross domestic product would drop 4%, and equity prices would drop 55%. Obviously, this is not what's happening right now and not what is projected to happen in the time frame, but the tests are meant to really stress the banks' operations.

And the 23 banks performed well. In this severely adverse scenario, the 23 banks would see a whopping $353 billion in loan losses over the nine-quarter period, which is equivalent to 6.2% of total loans. Despite this, the aggregate common equity tier 1 (CET1) capital ratio, a measure of a bank's core capital expressed as a percentage of risk-weighted assets such as loans, starts at 13% then dips to a low of 10.6% before rising back to 11.2% at the end of the first quarter of 2023. Maintaining those levels was quite impressive (banks' bare minimum CET1 ratio is 4.5%, though large banks would be in big trouble if it ever got that low). Even in this severely adverse scenario, the 23 banks in aggregate were able to maintain a CET1 ratio of more than double their bare minimum.

Individually, some banks dipped a little lower than the aggregate score. HSBC (HSBC 1.32%), for instance, would see its CET1 ratio dip to a low of 7.3%, while several other banks were in the 8% range, but this is still comfortably above the 4.5% bare minimum.

a piggy bank has stress clamps pushing in on it from different directions

Image source: Getty Images.

What does this mean?

While expected, passing stress testing means these banks are about to get a lot more discretion over how they repurchase shares and payout dividends, which will result in returning much more capital to shareholders.

In the early months of the pandemic, the Fed banned share repurchases and made it quite difficult to raise dividends in order to preserve capital headed into the economic uncertainty. As the pandemic began to ease and the future started to look brighter, the Fed eased these restrictions heading into 2021 and allowed repurchases to commence again, but limited dividends and repurchases based on profits made by the individual bank in the four preceding quarters. Now, with the restrictions slated to expire in just days, banks will be able to repurchase shares and pay out dividends as much as they want as long as they stay above their required regulatory capital thresholds set by the Fed.

With banks sitting on lots of excess capital, expect the floodgates to open. Based on what the bank is expected to have repurchased in the first two quarters of the year, JPMorgan Chase (JPM 1.93%) has authorization from its board to repurchase as much as $18 billion of shares for the remainder of the year, not that the bank will necessarily do that. Wells Fargo (WFC 0.89%), which was forced by the Fed's restrictions, to cut its dividend, and ended up cutting it 80% in 2020, is expected to begin raising its dividend back to more normalized levels. I would expect Bank of America (BAC 1.35%) to raise its dividend and repurchase shares, and much of these large banks will likely follow suit to the delight of shareholders. Next week, expect to start seeing announcements from banks on their plans.

Good news

While the stress testing results were somewhat expected, it's good news to finally see the limits on capital distributions officially fade. Even better is perhaps the fact that large banks, for the third time in roughly a year, have shown they can withstand a significant recession and still stay very well capitalized. This should be beneficial long term from a reputational standpoint, while the stock buybacks and dividend increases will help these banks in the near term.