Yesterday the US Federal Reserve released the results of its annual bank stress test, subjecting the 23 largest US lenders to a punitive set of scenarios. Some observers might think the events since March 2020 had been sufficient to test the resilience of the banks, but the Fed went beyond this recent real-life challenge and tested bank balance sheets against a range of hypothetical crises. These included domestic unemployment peaking at 10.8% in Q3 2022, a 4% decline in US GDP from Q4 2020 to Q3 2022, and an eye-watering 55% decline in equity values. The results showed these scenarios would result in a combined loss of $474bn for the sector, but despite this all banks passed the test with their capital ratios remaining above the regulatory minimum, due to the excess buffer capital they have built up over recent years.
In response the US regulator announced that from July 1, the temporary restrictions on distributions (share buybacks and dividends) would be lifted. US lenders are now widely expected to compensate equity investors with an imminent round of share buybacks and attractive dividend increases, which is understandable given the surplus capital evidently held across these institutions.
In the UK, meanwhile, the Bank of England’ stress test results were released back in March (with no major concerns) and the EU’s are due for release on the July 31. However, we would not be so confident that Europe’s regulators will be as quick to relax distribution guidelines. We believe the European banking sector will continue to grow capital ratios in Q2 and Q3 this year, but there appears to be more caution regarding the uniformity of the recovery in Europe; we expect continued scrutiny from the regulators and a more gradual relaxation for permitted distributions.
For bond investors this should be welcome news. A return to dividend payments is a healthy economic sign, but for holders of subordinated bank debt such as Additional Tier 1 (AT1), close regulatory scrutiny and controlled distribution points to healthy buffer ratios and that in turn offers comfort.
