The Federal Reserve's "stress test" annual report is coming this week! Will dividend payouts for US bank stocks face obstacles?

According to Zhītōng Cái Finance, analysts believe that this week's Federal Reserve regulatory report is expected to show that large U.S. banks have sufficient capital to withstand any renewed turmoil, but they will take a conservative approach to distributing dividends to investors in the face of economic and regulatory uncertainties. The Federal Reserve will announce the results of the annual bank "stress tests" on Wednesday, allowing investors to assess how much cash banks need to withstand a severe economic downturn and how much cash they can return to investors through dividends and stock buybacks.

A year ago, three U.S. banks collapsed due to the Federal Reserve's continued interest rate hikes squeezing regional banks' profit margins and their commercial real estate investment portfolios. Weakening consumer demand has also dampened confidence in the economic outlook. With more mid-sized banks joining the stress tests this year, the tests should provide new insights into the health of these banks. The annual assessment introduced after the 2007-2009 financial crisis is an essential part of bank capital planning.

The results may also push Wall Street banks to lobby the Federal Reserve to abandon plans to raise capital requirements. Wall Street banks argue that raising capital requirements is unnecessary as large banks already have ample cash reserves.

The U.S. banking industry will carefully study Wednesday's report, looking for evidence to support their views, while maintaining a cautious stance on dividends, as large-scale dividends and buybacks could weaken the banks' argument that "additional capital requirements will hinder their lending capacity."

Raymond James analyst Ed Mills said, "The stress tests may be used as a benchmark in the overall capital regulatory reform war. Capital returned to shareholders may increase, but the expected magnitude is not significant as capital standards have not been finalized."

This year, 32 banks will undergo testing. Wall Street giants JPMorgan Chase, Citigroup, Bank of America, Goldman Sachs, Wells Fargo, and Morgan Stanley are usually the most closely watched. Analysts at Keefe, Bruyette & Woods (KBW) believe that Citigroup, Goldman Sachs, and smaller banks like M&T Bank are expected to perform well due to changes in their balance sheet structures.

Concerns about regional banks persist among investors, with mid-sized banks such as Citizens, KeyCorp, and Truist likely to attract attention, while Discover Financial Services is also a focus of investor interest due to compliance issues making it a takeover target.

A bank spokesperson stated, "KeyBank is well-capitalized, with good credit quality and deposit conditions," and noted that KeyBank has moderate risk and diverse funding sources Key Factor: Commercial Real Estate (CRE) Exposure

The U.S. banking industry has performed well in recent years, although some critics argue that these tests are too simplistic. For example, in 2023, after the collapse of banks, the Federal Reserve was criticized for not investigating the ability of borrowers to withstand higher interest rates.

Analysts expect that the capital of all 32 banks will exceed the minimum regulatory requirements. Last year, the Federal Reserve found that in a severe economic downturn scenario, the 23 banks tested would collectively incur $541 billion in losses, but this would still leave their capital more than double the Federal Reserve's requirements. This year's test is similarly stringent, but includes around 10 banks with lower testing frequencies.

In the Federal Reserve's "severely adverse" scenario for 2024, the unemployment rate is projected to rise by 6.3 percentage points (from 6.4% in 2023) to peak at 10%. This includes significant declines in the stock and bond markets this year, but with a slightly milder decline in housing prices and the overall economy.

Similar to 2023, the test also anticipates a 40% decline in CRE prices, which is a concerning area as office vacancy rates and high property prices during the pandemic continue to pressure landlords.

The performance of a bank determines the size of its Stress Capital Buffer (SCB). The Stress Capital Buffer is additional capital that the Federal Reserve requires banks to hold beyond the minimum regulatory requirements needed to support daily operations, to withstand assumed economic downturns. The greater the losses under the test, the larger the buffer.

Analysts from Piper Sandler and KBW expect the overall group's SCB to remain relatively stable. However, KBW predicts a decline in Citigroup's SCB after selling most of its international consumer loans; and Goldman Sachs' SCB will also decrease due to reduced exposure in stocks and real estate investments. KBW states that efforts by U.S. manufacturing banks to reduce CRE exposure will also lead to a reduction in SCB size. KBW also suggests that KeyCorp and Truist's SCB may increase due to assumed income shocks.

Christopher Wolfe, North American Bank Ratings Director at Fitch Ratings, stated that investors will closely monitor the performance of bank CRE loans. He said, "Banks have set aside reserves of up to 10% for office loan portfolios, and compared to large banks, CRE will be a focus, but mainly for regional banks."