Regions Financial (RF -1.16%), a $153 billion asset bank based in Alabama, successfully passed the Federal Reserve's 2021 annual stress test, along with the 22 other banks that went through the exercise. But what makes Regions somewhat unique is that it was one of four banks that opted into stress testing this year even though it didn't need to.

With updated Dodd-Frank laws, only banks above $250 billion in assets must adhere to stress testing every year. Banks between $100 billion and $250 billion in assets only need to go through it every other year, but can opt in during off years. Regions opted in this year in an attempt to show investors that its credit quality is just as good as its peers', and to ultimately lower its capital requirements. Let's see if the bank has succeeded in its goals.

The stress capital buffer

One of the main bank capital ratios that regulators closely monitor is called the common equity tier 1 (CET1) capital ratio, which is a measure of a bank's core capital expressed as a percentage of its risk-weighted assets such as loans. Each bank's required CET1 ratio threshold is more or less determined by regulators and varies by the size and riskiness of a bank. But it's composed of a few different layers. Every bank no matter how big or small has 4.5% floor. Then most banks are also required to maintain a stress capital buffer (SCB) above the 4.5% floor.

While complex, the CET1 ratio is important because it determines how much capital banks must hold, and therefore how fast they can grow loans and how much capital banks can return to shareholders through dividends and stock buybacks. The Fed determines the SCB in part through stress testing. During stress testing, the Fed puts banks through hypothetical and stressed economic scenarios to ensure they can absorb the shock associated with a recession and still lend to families, individuals, and businesses during a downturn. This year, the Fed's severely adverse scenario looked at what would happen to banks' balance sheets if, between the fourth quarter of 2020 and the third quarter of 2022, unemployment rises 4% and peaks at 10.75%, gross domestic product drops 4%, and equity prices drop 55%. This is hypothetical --  not what is happening or what is expected to happen.

The Fed then determines the SCB by taking the difference between a bank's beginning and low projected CET1 capital ratios during a nine-quarter period of the projected stress test, and 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 a bank's CET1 ratio can really be is 7% of risk-weighted assets.

Person sitting at desk looking over charts and graphs.

Image source: Getty Images.

Will Regions get lower capital requirements?

Following 2020 stress testing results, the Fed determined that Regions' SCB would be 3%, which is high for the larger regional bank peer group -- nearly all of Regions' main competitors got the 2.5% floor. It may not sound like a lot but these percentages are out of tens of billions or hundreds of billions of dollars.

Now, this isn't the biggest deal in the world in terms of how 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%. Whether Regions' CET1 ratio requirement is 7% or 7.5% will not change that. Rather, the goal of opting into this year's stress testing was, as Regions CFO David Turner, explained, to send a message to the market about its credit quality.

"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," Turner said. "We don't believe that and we wanted a very public opportunity to demonstrate that. And that's really what this was all about."

The Fed will announce CET1 ratio requirements later this year, but we can do some very basic calculating on our own to determine what Regions' SCB will be with this new round of stress testing results. While the dividends as a percentage of risk-weighted assets can be more difficult to project, the CET1 differences are much easier. For instance, in the Fed's first round of stress testing in 2020 for its severely adverse scenario, Regions started with a CET1 ratio of 9.7% and it got as low as 7.3% in the Fed's hypothetical scenario. The difference there is 2.4%, so you can kind of see how Regions' SCB got to 3% because it was already near the floor without factoring in dividends.

In the 2021 tests, Regions did much better, starting with a CET1 ratio of 9.8% and only getting as low as 8.9% for a difference of 0.7%. Given how much lower that is from 2020, I think there is a very good chance Regions' SCB is lowered from 3% to 2.5% later this year.

Good news for the bank

The recent stress testing results are good news for Regions and indicate that the bank's SCB could be lowered later this year. This could allow Regions to manage its CET1 ratio down to the lower end of its 9.25% to 9.75% target range, which means potentially more capital can be returned to shareholders. In addition, the results send a message to the market that Regions' credit quality is indeed more similar to that of its peers.