The Federal Reserve recently released annual stress testing results for 23 of the largest banks with a presence in the U.S. During this exercise, the Fed puts banks through a hypothetical economic scenario to ensure banks can absorb the shock from a severe recession and still manage to lend to families, individuals, and businesses during a downturn. In this year's severely adverse scenario, over a nine-quarter period, the Fed had unemployment rising 4% and peaking at 10.75%, gross domestic product dropping 4%, and equity prices falling 55%.
All banks passed easily, maintaining strong capital levels, but some were able to make a profit during the nine-quarter stress test time frame, while the majority of banks reported losses. Now, this doesn't necessarily mean these banks are the best bank stocks, because the Fed's hypothetical scenario is nowhere close to happening, and the earnings power of some the banks mentioned here pales in comparison to others. But if you are looking to get some exposure to the banking sector and want the safest picks, then these bank stocks may be for you.
1. Bank of New York Mellon
Bank of New York Mellon (BK 0.72%) fared particularly well during the Fed's hypothetical downturn. Its regulatory capital ratios didn't dip too much, and during the nine-quarter stress period, the bank managed to generate $6.5 billion in net income before taxes. Keep in mind that this doesn't take into account $3 billion in losses from other comprehensive income (OCI), actual losses on certain investments and transactions, and accumulated other comprehensive income (AOCI), unrealized losses on certain investments and transactions. But even if you were to net those against net income before taxes, Bank of New York Mellon still would have the highest profits following the stress test.
This is primarily because Bank of New York Mellon is a large custodian bank, meaning it is mainly in the business of holding assets for safekeeping. It doesn't have the same exposure to loans or trading losses as other banks and therefore isn't as susceptible to losses during a significant downturn. That said, it also doesn't have nearly the same earnings power as other banks. During the nine-quarter stress period over which the Fed ran its simulation, Bank of New York Mellon posted pre-provision net revenue (PPNR), which is basically total revenue minus expenses, of $9.3 billion. In comparison, JPMorgan Chase, America's largest bank by assets, posted PPNR of nearly $57 billion during the Fed's hypothetical scenario. Still, Bank of New York Mellon is one of a handful of bank stocks that legendary investor Warren Buffett stuck by over the last year, even as he was selling many others -- this could be one reason that explains why.
2. State Street
Another large custodian, State Street (STT 0.03%), also fared well, generating $2 billion in net income before taxes over the nine-quarter period, with about half a billion in losses from OCI and AOCI. State Street's PPNR during the time period was only $4.4 billion, but again, like Bank of New York Mellon, the bank has limited exposure to loan losses, and trading and counter-party losses.
State Street also maintained very strong capital levels during the nine quarter stressed period. Its common equity tier 1 (CET1) capital ratio, a measure of a bank's core capital expressed as a percentage of risk-weighted assets started the stressed period at 12.3%, dips at one point to a low of 11.4%, and then rises back up to 13.3% by the first quarter of 2023.With a required CET1 ratio of only 8%, this leaves a lot of room to return capital to shareholders.
3. U.S. Bancorp
Another Buffett favorite, U.S. Bancorp's (USB 0.45%) stress testing results look great. During the severely adverse scenario, U.S. Bancorp would generate $1.5 billion in net income before taxes. The bank would see practically no impact from trading, OCI, and AOCI. Furthermore, unlike the two other banks on this list, U.S. Bancorp has considerably more earnings power. The bank's PPNR through this nine-quarter stress period would be $16.2 billion, which is toward the top end of the 23 banks that recently went through stress testing.
This is mainly because U.S. Bancorp has hundreds of billions of dollars in loans and a considerable payments business. The flip side is that these loans would result in U.S. Bancorp having to set aside $14.7 billion for potential losses. That's the push and pull of the loan business -- higher profit potential and higher loss potential. But the provision is just a loss on paper really done for accounting purposes, and doesn't necessarily mean the losses are official. Usually, the provision tends to be a lot higher than actual loan losses. For instance, following the pandemic, banks are releasing billions previously set aside for loan losses back into earnings because the losses never materialized. You never want to bank on releases, but it's something to keep in mind.