Federal Reserve Stress Tests: Catalysts For Bank Stocks

Summary

• Unique second round of bank stress tests to be conducted this year.
• Upcoming results to be released by bank, a usual departure from releasing aggregate data.
• Results expected to provide transparency and support to bank stocks.
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“Risk comes from not knowing what you’re doing.” - Warren Buffett

One upcoming catalyst for bank stocks is a second round of stress tests. Usually only one round per year is needed, but with continued uncertainty, further scenarios will be examined. After the second round, the Federal Reserve plans to publish firm-specific results, a deviation from standard policy where only aggregate performance is released, proving to be an interesting catalyst for the bank stocks.

June 2020 release

Recall the Federal Reserve released the results from the first round of stress tests in June 2020. The results indicated all banks had sufficient capital to withstand the scenarios considered at that time.

However, the possibility of large losses could not be overlooked and the Federal Reserve felt it was prudent to take actions to preserve capital. As a result, share repurchases were disallowed and bank dividends were capped at the current level. The prohibitions were put in place through the third quarter, though I expect them to be extended until the second round of stress tests is completed.

Second stress test scenarios

Two hypothetical scenarios will be considered in the upcoming round of stress tests. The first scenario is shorter, but harsher, as by the end of 2021 unemployment has jumped to 12.5%. A partial improvement comes sooner as unemployment falls to 7.5% in 2023. The GDP decline is roughly 3% through 2021. This is the “severely adverse” scenario.

In the “alternative adverse” scenario, the economic metrics do not worsen as much but stay lower for longer. Unemployment rises to 11% by the end of 2020 and then only declines to 9% in 2023. The GDP decline is lower at 2.5%. In the chart below, the unemployment rate for each scenario is shown.

Source: Federal Reserve

For comparison purposes, note the most recently reported unemployment rate for August 2020 was 8.4 percent.

Possible outcomes

The central bank is likely to focus on the health of consumer lenders in these stress tests. Both the ability to withstand losses but also the ability to continue lending to support further consumer growth will be considered. Banks with large credit card portfolios will also likely get a closer look, followed by an examination of the mortgage lending book.

Additionally, the scenarios consider stress in global markets and impacts on trading operations. Not only does the analysis consider the health of the trading book, but it will examine what happens should the bank’s largest counterparty defaults.

History of bank stress tests

Counterparty defaults were a huge concern during the 2008 financial crisis, which is when these bank stress tests were created. After realizing how unprepared the banks were to withstand shocks, the central bank began to require bank document solvency under economic downturns. While this does meet the goal of having a bank maintain enough capital to survive the worst of times, the reverse is true that maintaining extra capital ‘just in case’ of the worst does reduce the amount of lending done by the banks.

Summary

The results from the second round of stress tests are scheduled to be released by the end of 2020. Until then, I expect the bank stocks will likely trade in a range around current levels, pending the depth of information to be released with the results. But any release by the central bank will most likely include solutions, if needed, for the banks that will resolve any uncertainty and propel bank stocks higher. I’d look to buy bank stocks ahead of the stress test announcement.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.