All 23 banks required to participate easily passed the Federal Reserve's annual stress testing exercise, where the Federal Reserve puts the largest and most complex banks with a U.S. presence through a hypothetical adverse economic scenario to see how their balance sheets would hold up.
The goal is to ensure the safety and soundness of the banking system and to make sure banks can also continue to lend during a difficult economic scenario.
These super-regional bank stocks were facing increased pressure from investors and customers related to a banking crisis earlier this year. Let's take a look at which banks performed the best in this latest round of stress testing.
Assessing regulatory capital requirements
While regulators use bank stress testing for safety and soundness, investors are looking at it because it helps determine regulatory capital requirements for banks. One of those is the common equity tier 1 (CET1) capital ratio, which looks at a bank's core capital as a percentage of its risk-weighted assets, such as loans. A lower CET1 requirement means more excess capital for dividends and share repurchases, whereas a higher requirement means the opposite.
Stress testing helps determine one layer of the CET1 called the stress capital buffer (SCB). It does this by looking at where a bank's CET1 ratio is at the beginning of the nine-quarter stressed period. The difference between the start and the low point of the CET1 during the simulation plus four quarters of projected dividends equals the SCB.
Not all super-regional banks have to do stress testing every year, and this year only six banks participated. In the chart below, I looked at what each bank's SCB was during this year's stress test and then compared it to each bank's current SCB.
| Bank | Actual CET1 Q4 2022 | Minimum CET1 | SCB excluding dividends | Current SCB |
|---|---|---|---|---|
| U.S. Bancorp (USB 0.32%) | 8.4% | 6.6% | 1.8% | 2.5% |
| PNC Financial Services Group (PNC -0.12%) | 9.1% | 7.9% | 1.2% | 2.9% |
| Truist Financial Corp (TFC 0.53%) | 9% | 6.7% | 2.3% | 2.5% |
| M&T Bank (MTB -0.35%) | 10.4% | 7% | 3.4% | 4.7% |
| Citizens Financial Group (CFG 0.43%) | 10% | 6.4% | 3.6% | 3.4% |
| BMO Harris (BMO -0.77%) | 12.6% | 9.3% | 3.3% | 3.4% |
Source: Federal Reserve
As you can see, Citizens Financial Group performed the worst of these six stocks. Its SCB for this upcoming year is going to be 3.6% plus projected dividends, which is higher than its current SCB of 3.4%. This will likely push up its CET1 requirement later this year, and there are other regulatory capital changes expected as well that may also increase super-regional bank capital requirements.
PNC, which is known as a conservative commercial lender, performed the best, with just a 1.2% SCB not including dividends. That's going to be a big improvement from the bank's current SCB of 2.9%, although the lowest an SCB can be is 2.5%. Still, this would allow PNC to potentially lower its CET1 requirement, depending on what other changes come.
When you look at the difference between PNC and Citizens, the Fed's stress test modeled a higher loan loss rate for Citizens. In the Fed's hypothetical scenario, which has unemployment rising to 10% and commercial real estate prices falling by 40%, Citizens had a 7.1% projected loan loss rate, while PNC's was only 5.5%. PNC also had higher expected pre-provision net revenue.
Capital return plans still uncertain
As I mentioned above, other regulatory capital changes, particularly for super-regional banks, are expected later this year, which will likely keep most super-regional banks in a wait-and-see mode in terms of dividends and share repurchases.
But PNC looks to have made the most improvement on their SCB. M&T and U.S. Bancorp also performed well. Meanwhile, Truist, BMO, and Citizens did not perform as well and are likely to have similar SCBs as they have now or slightly higher.
