US banks face toughened Fed stress test this year, but most are well-prepared for the worst

Every year, the largest US banks (NASDAQ:KBWB) will have to undergo the “Dodd-Frank Act Stress Tests (DFAST)” conducted by the regulators. This year is no exception, but in light of the COVID-19 pandemic, the Fed created a special test that assumes harsher economic conditions. Here are the main points you should take note of.

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  • Published on 23 Jul 2020

US banks face toughened Fed stress test this year, but most are well-prepared for the worst | Open a FREE FSMOne account and manage all your investments conveniently in ONE place
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The Federal Reserve has released the initial results of its annual stress test on the 25 June 2020. In light of the COVID-19 pandemic, the Fed has also released a special report to further test the banks under three harsher alternative scenarios: V-shaped, U-shaped, and W-shaped recovery.

The good news here is that even under these harsher conditions, the results have shown that most banks remain well-capitalised. However, several firms could experience significant capital depletion, causing them to approach the minimum capital requirements.

The Fed recognised the economic uncertainty in the current market and decided to restrict capital distributions to ensure that the banks remain strong to weather through this pandemic-induced downturn. However, we believe JPMorgan (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC) will be able to offer a decent yield of 2.5% after taking into account dividend withholding tax.

With an average upside potential of approximately 20% in the next 1 to 2 years, we believe that banking stocks will be an interesting addition to your portfolio.

Investors who prefer to have a more diversified exposure to the US banking industry can opt for the Invesco KBW Bank ETF (NASDAQ:KBWB).

Every year, the largest US banks will have to undergo the “Dodd-Frank Act Stress Tests (DFAST)” conducted by the regulators. Introduced in 2013, the stress test puts US banks through various adverse economic scenarios to assess the banks’ ability to withstand a potential market downturn.

2020 bank stress test results


This year’s results have shown that the banks are able to withstand severe economic downturns as they remained well-capitalised even in severely adverse scenarios. However, as no one could have predicted the unprecedented COVID-19 crisis, the Fed released a special report to further test the banks under three harsher alternative scenarios in light of the pandemic:

  1. V-shaped recovery: A quick recovery where the economy regains much of the output and employment lost by the end of this year.
  2. Long U-shaped recovery: Only a small share of lost output and employment is regained in 2020.
  3. W-shaped double-dip recession: A short-lived recovery followed by a second wave of COVID-19 disruption.

Under these three scenarios, unemployment rates peaked at levels ranging between 15.6% and 19.5%, which is not too far away from June’s unemployment rate of 11.1%. Loan losses across the 33 banks subjected to the stress test could hit USD 700 billion, translating to a loan loss rate of 10.3%. To put things in perspective, the actual loan loss rate during the Global Financial Crisis was only 6.8% (Chart 1). 

Chart 1: Historical and projected 9-quarter loan loss rates

The good news here is that even under these harsher conditions, the results have shown that most banks remain well-capitalised. This means that we will probably not witness another massive bank bailout like what happened in 2008. However, it was highlighted that, under the U-shaped and W-shaped recession scenarios, “several firms could experience significant capital depletion, causing them to approach the minimum capital requirements” (Chart 2).

Chart 2: CET1 results in various scenarios


Unfortunately, the Fed did not disclose the individual banks’ financial position outcome for this special COVID-19 stress test. Hence, we can only infer who might be the firms that will approach the minimum capital requirements in the event of a U-shaped or W-shaped recession based on the results of the traditional stress test.

We believe firms that have CET1 ratios in the lower bounds and firms with the largest declines in their CET1 ratios in the severely adverse scenario will likely be one of the “several firms that could experience significant capital depletion” during the U-shaped or W-shaped recessions. Table 1 shows the ten banks that have fared poorly in the traditional stress, starting with BMO Financial that ranks the lowest among all the banks tested. 

Table 1: Top ten firms that have CET1 ratio in the lower bounds and with the largest declines in CET1 ratio in the traditional stress test
Ranking Company Name Included in KBWB ETF?
1 BMO Financial No
2 Capital One Yes (3.7%)
3 Goldman Sachs No
4 Ally Financial No
5 HSBC North America No
6 Citizens Financials Yes (3.6%)
7 Regions Financial Yes (3.3%)
8 Truist Financial Yes (4.0%)
9 Discover Financial No
10 MUFG Americas No
Source: Federal Reserve System: Dodd-Frank Act Stress Test Results 2020, iFAST compilations
Data as of June 2020

While JPMorgan, Citigroup and Bank of America’s individual financial positions were not disclosed in this special test, we believe their minimum CET1 ratios belong to the top 50th percentile based on the traditional stress test results, putting them in the safe zone for now.

Capped dividends and suspended buybacks in the third quarter this year 


In light of these results, the Fed recognised the economic uncertainty in the current market and took several actions to ensure that banks remain strong to weather through this pandemic-induced downturn. 

It was announced that no share buybacks will be permitted in the third quarter and banks are also not allowed to increase their dividends more than what they paid in the second quarter either. The Fed has also imposed an additional rule stating that dividends paid must not exceed an amount equal to the firm’s average net income in the last four quarters. 

The good news here is that JPMorgan, Citigroup and Bank of America, have all announced that they will maintain their dividends for the third quarter. While we reiterate that common dividend payments will not take a huge bite out of the banks’ capital, the additional rule of capping dividends based on the firms’ average net income may lead to dividend cuts in the next few quarters. 

Based on the first and second-quarter earnings results, the loan loss provision was the main culprit that dragged down the banks’ net income. However, if we use the average earnings from 1H20 as a gauge, it seems that the big banks will still be able to maintain their dividends for the rest of the year, except for Well Fargos (NYSE:WFC) given its poor earnings results.

Table 2: Banks may be forced to cut their dividends if quarterly dividends is higher than the firm’s average net income in the last four quarters

3Q20 dividends

Average earnings per quarter*

JP Morgan (NYSE:JPM)

0.90

1.08

Citigroup (NYSE:C)

0.51

0.78

Bank of America (NYSE:BAC)

0.18

0.39

Wells Fargo (NYSE:WFC)

0.51

-0.33

Source: Companies' respective quarterly reports, iFAST compilations
*Average of 1Q20 and 2Q20 net income
Data as of July 2020


Besides, given the forward-looking nature of the new account standard (CECL), JPMorgan’s CEO has highlighted that they will front-load the banks’ credit reserves in the first two quarters but expect the loan loss provisions to taper off in subsequent quarters.


Therefore using the management’s guidance, the third and fourth-quarter earnings results may be better in comparison to the first half of 2020, giving the three banks the green light to continue their dividend payments while maintaining healthy capital and liquidity positions (Table 3). Based on their respective third-quarter dividends, the three US banks are yielding at approximately 2.5% after taking into account dividend withholding taxes. 

Table 3: US banks continue to be on solid footing

CET1 Ratio

Fed's minimum requirement for CET1

JPMorgan (NYSE:JPM)

12.4%

11.3%

Citigroup (NYSE:C)

11.5%

10.0%

Bank of America (NYSE:BAC)

11.6%

9.5%

Source: Companies' respective quarterly reports, iFAST compilations
Data as of July 2020


Banks’ valuations remain cheap even when the broader market has recovered 


Overall, while the broader market has recovered to almost pre-COVID levels, the KBW Nasdaq Bank Index is still down by over -30%. Economic uncertainty continues to linger in the market and coupled with the upcoming elections, it will probably be yet another few volatile quarters for the banking industry. 

However, for those that can handle the ups-and-downs in the market, we believe that banking stocks will be an interesting addition to your portfolio, especially if you are looking to participate in the recovery of the US economy. At their current valuation levels, we see an average upside potential of approximately 20% in the next 1-2 years. 

Table 4: Top 3 US commercial banks offering decent upside potential

PB ratio

Target price (USD)

Current price (USD)

Upside potential

Dividend yield*

JPMorgan (NYSE:JPM)

1.6

119.1

98.7

20.7%

3.6%

Citigroup (NYSE:C)

0.8

61.7

51.7

19.3%

3.9%

Bank of America (NYSE:BAC)

1.1

28.8

23.6

18.5%

3.0%

Average:

19.5%

3.5%

Source: Bloomberg Finance L.P., iFAST estimations

*Dividend for the next four quarters is assumed to be maintained at current levels
Data as of July 2020


For a more diversified approach, we recommend the Invesco KBW Bank ETF (NASDAQ:KBWB), which tracks the performance of 24 leading banks and thrifts that are publicly-traded in the US. With an expense ratio of 0.35%, it will be able to help investors get exposure to the US banking industry without eating away their returns.

Chart 3: KBW Nasdaq Bank Index should track its book value


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