If you own bank stocks, or are thinking of getting in, I have a warning for you today…
Bank shareholders may be seeing some light at the end of the tunnel.
The American banking sector got good news recently. And it’s celebrating… by promising to pay out higher dividends.
But as I’ll show you today, news coming out this week may overshadow the celebrations. And it may cause banks to hit the pause button on the party.
So today, I want to make sure you’re prepared – and know what to look out for…
Fed Tests Banks’ Resilience to Risk
First, the good news…
Once a year, the Federal Reserve tests banks. This is to see if they can navigate stressful financial and economic conditions. Media and economic commentators refer to these tests as “stress tests.”
The tests evaluate whether banks have enough liquid capital to continue operations during times of economic and financial market stress.
The idea is that they should be able to make payments on their own debt and lend to households and businesses.
The tests also determine whether banks have solid capital-planning strategies in the event of extreme-risk conditions.
The Fed then uses the stress test results to set something called the stress capital buffer (SCB) requirement.
This is the level of capital each bank is required to keep on hand. It’s based on its risk profile and likely losses as measured by the Fed’s stress tests.
The parameters for this year’s stress tests were set in February.
They supposed a 3.5% decline in GDP for 2022 and an unemployment rate of 10%. They also included a 55% drop in stock prices and a 40% plunge in commercial real estate values.
The Fed’s stress tests are supposed to determine whether banks have enough money on hand to absorb losses in the event of these stressful economic conditions.
And of course, the overall aim is to avoid any banks requiring a bailout from the taxpayers…
What Stress Tests Say About Wall Street
The 2022 results came out in the last couple of weeks. So how did the banks do?
Well, if this Bloomberg headline is anything to go by, they did pretty well…
Banks Ace Fed Stress Tests, Pave Way for Shareholder Payouts
All 34 U.S. banks tested passed their stress tests. This means that the Fed decided they could all survive a major economic downturn without needing a bailout.
And if you just read the headlines, you might be under the mistaken impression that everything is rosy on Wall Street…
But looking under the hood, it’s clear some banks did better than others.
Gold stars went to Goldman Sachs, Morgan Stanley, and Wells Fargo. They all got lower SCB levels. In fact, Goldman’s SCB fell by 10 basis points. That was due to growth in its consumer business.
But several banks might need to increase the level of capital they have in reserve. This group includes Bank of America, Citigroup, and JPMorgan Chase.
Bank of America and JPMorgan Chase are concerned they might start to see more defaults in credit or loan payments.
For Citigroup, higher trading losses, lower fee income, and higher expenses impacted their capital levels.
Good, But Not As Good As Last Year
But deciding on the banks’ SCB levels isn’t the only outcome of the stress tests.
The Fed also uses the results to determine whether banks can redistribute some of their excess capital to shareholders in the form of dividends, or even share buybacks.
Typically, those that do not perform well in the stress tests are not allowed to raise their dividends. They may also be required to hold off on stock buybacks until they raise the amount of liquid capital they have on their books.
Following their stress test results, Goldman Sachs, Morgan Stanley, Bank of America, and Wells Fargo raised their dividends.
But if you look closer, you’ll see that the increases were much lower than last year.
Last year, Goldman Sachs raised its dividend by 60%. This year, it will raise dividends for the quarter by 25% to $2.50 per share.
In 2021, Morgan Stanley doubled its dividend after the stress tests. This year, it raised its dividend by just 11% to 77.5 cents per share. It also announced that it would initiate a $20 billion share buyback program.
Bank of America raised its quarterly dividend by 5% to 22 cents per share. But that’s significantly lower than last year’s increase of 17%.
And, having doubled its quarterly dividend after the 2021 stress test, this year Wells Fargo raised its dividend by just 20% to 30 cents a share.
So, most of the banks are being cautiously optimistic… And JPMorgan Chase and Citigroup are not increasing their dividends at this time.
But, as I mentioned up top, there’s something happening soon that might show the banking industry in a different light…
What This Means for Your Money
Starting on Thursday, banks will release their second-quarter earnings reports. And I believe we are likely to see signs that banks are doing less well than the stress tests indicate.
That’s because quarterly earnings show what’s actually going on, not how those businesses would do in a hypothetical scenario.
According to my sources on Wall Street, trading and investment bank fee volume, in particular, will be down significantly this quarter.
Remember, the criteria for the stress tests were set in February. That was before the war in Ukraine began… and while the Fed was still ignoring rising inflation.
A lot has changed in the world and in the markets since then.
So, until we can reassess how healthy the Wall Street banks really are after this earnings period, I suggest you steer clear of megabank stocks for now.
Editor, Inside Wall Street with Nomi Prins
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