The Federal Reserve recently released the results of its 2023 stress testing exercise, in which it puts the largest and most complex banks through a hypothetical adverse economic scenario categorized by a severe recession and high unemployment. The Fed then models out a bank's financials, including its capital, profitability, loan losses, and more, to ensure that the U.S. banking system could not only survive a severe economic scenario but also continue to lend.
Stress testing is also closely watched by investors because it helps determine regulatory capital requirements for banks, namely the common equity tier 1 (CET1) capital ratio, which looks at a bank's core capital, expressed as a percentage of its risk-weighted assets such as loans. The CET1 ratio determines how much capital banks must hold, and therefore how much excess capital they have for dividends and share repurchases.
In this year's stress testing, all 23 banks breezed through the exercise, having ample capital despite a scenario that included unemployment rising to 10% in the two-year stressed window, and commercial real estate prices falling a whopping 40%. Here are the three big winners from this year's stress testing.
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1. JPMorgan Chase
Stress testing only determines one layer of the CET1 ratio, and that layer is called the stress capital buffer (SCB). This layer is determined by looking at the difference between a bank's CET1 ratio at the beginning of the nine-quarter modeled test and the low point of the CET1. The difference plus four quarters of projected dividends makes up the SCB.
After last year's stress test, JPMorgan Chase (JPM 0.06%), the largest bank by assets in the U.S., had an SCB of 4% and a CET1 requirement of 12%.
In this year's stress test results, the difference between JPMorgan's beginning CET1 and the low point was only 2.1%, which means that even after adding dividends, its SCB will likely fall materially. In the simulation, JPMorgan could incur nearly $73 billion of loan losses and just below $18 billion of trading and counterparty losses and still maintain a CET1 ratio above 11%. This shows just how much capital the bank has built in recent years.
At the end of the first quarter, JPMorgan Chase had a 13.8% CET1 ratio. While banks are still waiting for other potential regulatory capital changes that are expected to come out later this year, JPMorgan's outlook for capital returns has improved dramatically, and I could see the bank raising its dividend and restarting share repurchases soon.
2. Bank of America
America's second-largest bank by assets, Bank of America (BAC -0.21%), also performed incredibly well, with arguably the best showing in its peer group. The bank's CET1 ratio started the stress test period at 11.2% and only fell to a low point of 10.6%, which is actually above its current requirement. That's superb, as most banks in this hypothetical scenario will typically fall below.
The Fed doesn't allow large banks to have less than a 2.5% SCB, and Bank of America is currently at a 3.4% SCB. In the Fed's model, Bank of America would be able to maintain very strong capital ratios, despite incurring more than $54 billion of loan losses and nearly $9 billion of trading and counterparty losses.
Bank of America didn't stop repurchasing stock this year, either. While the bank is still waiting on other potential regulatory capital changes, these results should open the door for more aggressive share repurchases once the other regulatory capital changes are known -- and maybe a dividend increase as well.
3. Morgan Stanley
Investment bank and wealth manager Morgan Stanley (MS 0.29%) also made a strong improvement this year, with its CET1 ratio entering the stressed period at 15.3% and hitting a low point of 11.2%, for a difference of 4.1%. Morgan Stanley's current SCB is 5.8%, so even when you add the dividends, I still expect to see Morgan Stanley's new SCB fall.
Morgan Stanley managed this performance while incurring roughly $10 billion of loan losses and $12.5 billion of trading and counterparty losses. In fact, during the nine-quarter stressed period, Morgan Stanley would only generate a loss before taxes of $3.7 billion, which is far smaller than JPMorgan or Bank of America.
Morgan Stanley repurchased $1.5 billion of stock in the first quarter, so I think the outlook for capital returns moving forward looks good, barring no major surprises when the other expected capital changes come out later this year.
