As if the last few months weren't big enough for bank stocks, the sector is staring down what could be another significant month in June as it awaits new regulatory requirements and stress-testing results from international and domestic regulators.
Banks must set aside capital when they take on risk through activities such as lending and trading, and regulatory capital is huge in banking. It impacts a bank's appetite for lending, bank returns, and how much capital banks can return to shareholders. Here's why June will likely be a big month for bank stocks.
What is the Basel III Endgame?
The first proposed regulatory capital changes that could be released this month are referred to as the Basel III Endgame. The Basel Committee on Banking Supervision is an international body composed of regulators from all over the world that takes the lead on setting global bank regulations. Basel III Endgame is a set of revisions to Basel III, which is an international framework of regulations implemented in 2017 in response to what happened to the global banking system during the Great Recession.
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Citing anonymous sources, The Wall Street Journal recently reported that these revisions could increase bank capital requirements by about 20% for the largest banks in the country like JPMorgan Chase. Whether the final rules would apply to banks with between $100 billion and $250 billion in assets remains to be seen, but after the now-ended banking crisis earlier this year, it's now much more of a possibility.
According to the Journal, banks that are heavily dependent on fee revenue, like big wealth managers such as Morgan Stanley, could also face higher capital requirements for these activities. This would certainly be an interesting development, as many large banks have leaned into asset and wealth management or businesses like payments and investment banking because of their favorable capital treatment.
The Basel Endgame revisions are more widely expected to impact bank capital by placing higher requirements on bank trading activity. The rule that will likely shape this is the Fundamental Review of the Trading Book, which will more clearly define trading assets versus banking assets that are supposed to be held to maturity and those intended for trading. While it's quite complex, the consensus is that banks are going to have to hold more capital against their trading assets such as derivatives.
Stress testing
The other big impact on bank capital is the release of stress-testing results, which typically come out in June. In this annual exercise, the Federal Reserve puts large bank balance sheets through a hypothetical adverse economic scenario, usually including a severe recession and high unemployment. The goal is to see that banks would be able to maintain healthy levels of capital and continue to be able to lend during the downturn.
The stress-testing results determine a portion of each bank's common equity tier 1 (CET1) capital requirements, which look at a bank's core capital expressed as a percentage of its risk-weighted assets such as loans. The CET1 ratio is one of the main ratios that regulators set requirements for, and it is the excess capital over the requirement that banks can use to return capital to shareholders.
Even before the banking crisis, Fed stress testing was shaping up to be an interesting year. For the first time, the Fed is planning to put the eight largest global systemically important banks (G-SIB) through an exploratory market shock. This will put the eight G-SIBs through a different market shock in addition to the one the Fed plans to apply to all large and super-regional banks it is testing. While the exploratory shock will not contribute to this year's capital requirements, it will likely influence how banks prepare for capital requirements moving forward.
On Q1 earnings calls, bank CEOs in general seemed pretty uncertain about what the stress-testing results would look like and how severe the Fed's modeling will be this time, especially after the banking crisis.
How high will the requirements go?
Banks have been anticipating Basel Endgame and stress testing, and have been building significant capital in anticipation. For instance, JPMorgan has built its CET1 ratio to 13.8%, which is up 1.9% from the first quarter of 2022. Considering these percentages are based on billions and trillions of dollars, that's a huge amount of capital.
The big question for both Basel III revisions and stress testing is whether banks prepared adequately enough, or if changes from Basel and stress testing will require banks to raise their CET1 ratios even more. If they do need to do this, it could impact bank share repurchases and dividend plans this year, which are always a big part of the investment thesis regarding these large banks. If it turns out that banks did prepare adequately, then the market may reward them.
