After a year of strong stimulus support to the economy and constraints on shareholder payouts, US banks are now flush with liquidity and surplus capital. They stand ready to deliver the much awaited shareholder bonanza as the payout restrictions expire on June 30th. The US Fed’s DFAST results from last evening have also reinforced the high loss-absorbing capacity of the banking system, removing the last hurdle to return capital to shareholders.

No prizes for guessing the results; but SCB rejigs on the cards

As was widely expected, all 23 participating banks completed yet another round of successive ‘all pass’ results, with the Fed proudly stating that even after being hit by a projected $474 billion losses (including $353 billion in loan losses, similar to the June 2020 cycle) over the nine quarter-period, i.e., from first quarter of 2021 to first quarter of 2023, in the severely adverse scenario, the aggregate Common Equity Tier 1 (CET1) of banks would stand strong at 10.6%, which is more than double the minimum requirement. However, the story could be deviate across individual banks.

Based on the stressed CET1 declines (see chart 1), we believe there is a good chance that Citigroup and Wells Fargo may see their stress capital buffers (SCBs) rise marginally, while Goldman Sachs and Morgan Stanley could see slight declines. For those unaware, the SCB is a dynamic capital surcharge assigned by the Fed in lieu of the capital conservation buffer; they are floored at 2.5% but may be higher depending on the risk profile of the bank as revealed by the outcome of the DFAST in each cycle.

In our view, Citi’s results are likely to have been impacted by low rates and credit card losses, whereas Wells Fargo’s projection is likely to have been impacted by harsh loss rates on its commercial real estate exposures. Citi may have to wait on the planned closure of the sale of its Asian operations before it may gain some relief from G-SIB surcharges. Among the US non-global systemically important banks (G SIBs), Capital One Financial Corp. and Regions Financial Corp. could also see their SCBs decline.

Shareholder payouts to soar; but specifics would only be revealed next week

Ever since the Fed’s announcement in March 2021 that the capital distribution restrictions will expire on June 30, 2021, the market as well as the banks have been eager to kick-start aggressive payouts. However, unlike previous cycles where all banks would rush to disclose their shareholder payout plans immediately after the results, this time around the Fed has asked them to fully reflect upon the results, and wait until the close of market (4:30pm EDT) on June 28 before making public their payout plans and also their new SCB requirements. The Fed has also stated that the new SCBs would only apply as of October 1 2021.

Thanks to strong stimulus programmes and shareholder payout restrictions that have been in place for about a year now, banks have been building up capital buffers. They are also flush with liquidity, with aggregate loan-to-asset ratio of banks at just 48.1%, and cash assets at a whopping 17.6% of total assets (Fed data as of June 9, 2021).

Chary of the risk of rising rates – with opinion on the inflation path divergent – banks aren’t willing to switch their cash balances into securities. JPMorgan also recently commented that the loan-to-deposit ratio is close to a 50-year low, and middle-market business-loan utilisation is as low as it has ever been. But there is still significant scope for high payouts – including for Citi and Wells despite the possibility of them being assigned higher SCBs– as these banks benefit from very high excess capital (i.e. end-Q1 2021 CET 1 ratios over current respective minimum requirements) compared with their market cap (see chart 2). 

According to our calculations, aggregate excess capital for the eight US G-SIBs stood at $130.1billion (as of end-Q1 2021), and this would increase further with the second-quarter earnings added. These banks also have good earnings power, as they generated an aggregate $88.4 billion in net earnings in FY 20 (which translated to 130bps of end-FY 20 CET1 capital ratio). Hence, and despite the expected SCB rejigs, even a conservative estimate would mean aggregate payouts by the US G-SIBs and other US banks could be well above $100 billion over the next 12 months. However, given this year’s rally in banking stocks, it would be interesting to see the buyback versus dividend mix in the ultimate payouts.

Regions proves its point

Alongside three foreign banking organisations, Regions was the only US bank that participated voluntarily in the current round, even though it wasn’t mandated to. After having been handed out a relatively high SCB of 3.0% (effectively, a minimum CET1 ratio requirement of 7.5%) by the Fed last August, the bank was determined to make a statement to the market that its SCB does not fully reflect its underlying business model – the effort may have just paid off. The projected CET1 decline (end-FY20 to minimum point) was a mere 100bps in the current cycle’s tests as opposed to 180bps and 140bps, respectively, in the December 2020 and June 2020 rounds. The end-first quarter 2021 CET1 ratio of the bank was 10.3%, and it has guided a targeted range of 9.25%-9.50%. 

Note for modelers: model adjustments had net negative impact

Just as it does every cycle, the Fed continued to make adjustments/enhancements to its modelling methodologies. This cycle, the adjustments primarily related to three categories – i) smoothening out of the 2020 unemployment rate inputs to the autos and credit card PD models to eliminate the effect of high data volatility last year; ii) reversal of a lower bound adjustment to the collateral recovery rates for hotel properties that was incorporated in the December 2020 DFAST to reflect the stabilising hotel property values; and iii) similar to the December 2020 DFAST round, the Fed adjusted the calculation of payment status for first-lien mortgages in forbearance to standardise reporting practices across firms. While adjustments to the hotel collateral recovery values reduced projected loan losses, the other two adjustments increased projected loan losses.

So, what’s next?

The upcoming earnings season may not be very exciting for US banks, as revenues are likely to remain depressed. Net interest income is likely to be impacted by a combination of stagnant loan balances and low interest rates. Market-making revenues would come in lower, primarily because of the base effect from extraordinary results in the second quarter of 2020, which was driven by the stimulus effects that drove client activity. A partial offset could come in the form of investment banking revenues, with deal-making and primary capital market activity remaining buoyant in the quarter. 

The outlook for the banking sector would depend heavily on the recovery in consumer spending and whether interest rates start rising much sooner than the Fed’s expectations of rate hikes in 2023. However, it is also too early to rule out crystallization of asset quality risks from select sectors that have been hard-hit by COVID-19.