It's been a tough year for bank stocks. Since SVB Financial's Silicon Valley Bank collapsed in March, bank stocks have been under the microscope. Investors are combing through balance sheets to see what banks have problems with their deposits or loan books.
One heavily scrutinized bank is U.S. Bancorp (USB 0.32%). Concerns about the bank center on how much capital it must hold after its acquisition of MUFG Union Bank. Investors recently got some good news from the Federal Reserve on this front. Here's what it is and how U.S. Bancorp will be affected.
U.S. Bancorp's recent acquisition put pressure on its regulatory capital ratios
Investors have been focusing on U.S. Bancorp's capital ratios amid its acquisition of MUFG Union Bank. Finalized in December, the acquisition significantly expanded its presence on the U.S. West Coast.
Banks must comply with capital ratios set by regulators to ensure they have enough an adequate financial cushion to withstand financial distress in the event of significant loan losses. One ratio that measures a bank's financial strength is the common equity Tier 1 (CET1) ratio. This ratio takes the bank's core capital as a percentage of its risk-weighted assets, such as loans.
After U.S. Bancorp's acquisition of Union Bank, its CET1 ratio fell from 9.7% to 8.4%. This ratio was the lowest among the 23 banks subject to the Fed's annual stress tests and well below the average CET1 ratio of 12.4%.
The bank faced more stringent capital requirements
As part of its acquisition, U.S. Bancorp committed to submitting quarterly implementation plans for complying with Category II banking requirements. These requirements apply to banks with $700 billion or more in assets and impose more stringent capital requirements.
Category II banks must include unrealized losses on the bonds they intend to sell before maturity in their regulatory capital ratios. Under these new rules, U.S. Bancorp's CET1 ratio would be 5.8%, well below the 7% requirement. The bank would've had until the end of 2024 to comply with these requirements.
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Why the Federal Reserve releasing U.S. Bancorp from these requirements is a "game changer"
On Oct. 16, the Fed released U.S. Bancorp from those commitments, while also exempting the bank from quarterly implementation plans.
The move alleviates pressure from U.S. Bancorp to meet more stringent regulatory requirements. It also means the bank will shrink its assets to avoid Category II bank classification. It currently has $665 billion in assets, just below the $700 billion threshold. According to the Fed, the bank said "it anticipates taking further actions to reduce its projected risk profile, including further net reductions in assets and increases in regulatory capital."
Analysts who cover the bank expressed optimism. UBS said the move is a "game changer," representing a "major, unexpected regulatory victory" for U.S. Bancorp. Bank of America also described the move as "a significant positive."
Here's what you need to know before you buy the bank
U.S. Bancorp is one of the U.S.'s highest-quality banks, so seeing the stock beaten down earlier this year was a bit of a surprise. The recent decision to release the bank from the Category II regulatory requirements is good news. It takes some pressure off management to meet stringent capital requirements by the end of next year.
Its recent earnings show the bank is moving in the right direction, as its CET1 ratio improved for the third consecutive quarter to 9.7%.
Data source: YCharts
Investors who buy the bank today would get it at its cheapest valuation since the Great Recession. Its relatively low price provides some margin of safety, but it's not a riskless investment, considering the current environment for banks.
Bank stocks would benefit from a pause (and even more from a cut) in the Fed's interest rate hikes. This would give them more certainty about future interest rates and take the pressure off their loan books, which lose value every time interest rates increase. Until that happens, banks will continue to face elevated scrutiny and volatility.
