Federal Reserve Stress Tests: Catalysts For Bank Stocks

Sep. 29, 2020 12:05 PM ET1 Comment

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


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This article was written by

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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.

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