After a quarter of broadly negative ratings actions on the banking sector that felt like a storm of falling anvils, the release of the Federal Reserve Dodd-Frank Act Stress Test ("DFAST") and Comprehensive Capital Analysis and Review ("CCAR") afforded some relief for bank credit investors.

Rob Hajduch, Principal Credit Analyst

The results of the Federal Reserve's annual stress test (DFAST) on the U.S. banking system were released late yesterday afternoon simultaneously with the annual CCAR. The stress scenario applied for the exercise was consistent with current economic conditions assuming a "V" shaped recovery in the current year. All participating institutions performed well within that context, with capital builds over previous years allowing for the system to broadly absorb emerging losses and remain "well capitalized".

Unlike other years, however, the Fed overlaid the current stress test with a sensitivity analysis that incorporated the COVID-19 pandemic impact on economic conditions that would drive both "U" and "W" shaped recoveries. Under the latter scenarios, 25% of participating institutions would have Common Equity Tier I ratios of 5.5% or less ("U" shaped), or 4.8% or less ("W" shaped) against a 4.5% minimum level.

To ensure the system's resiliency in the event of a more prolonged ("U") or volatile ("W") downturn, the Fed announced the following:

  • Prohibition of share repurchases for Q3 2020 except for those related to employee stock ownership plans.
  • Common equity dividends are capped at Q2 2020 levels and payments going forward are limited to levels that do not exceed trailing four calendar quarters average net income.
  • Scheduled payments on hybrid equity capital (preferred equity and subordinated debt) are permitted, although redemption of Tier I instruments in Q3 2020 is prohibited.
  • To address the potential for the "U" and "W" scenarios, a Stressed Capital Buffer will be implemented in Q4 2020 and integrated into the CCAR process this year and: 
    • The Board will provide updated scenarios to participating institutions at a later date, after which banks are required to resubmit capital plans within 45 days for reassessment by the Fed.
    • Dividend restrictions and other provisions may be extended at the Fed's discretion on a quarter-by-quarter basis. 

Within our coverage universe, Wells Fargo and Capital One appeared to be the only banks that could potentially lower dividends in Q3 under the current conditions. Citizens, Huntington and KeyCorp are the most likely to see dividend cuts under the more adverse scenarios (Barclays Equity Research). In any event, the results are constructive from a credit standpoint, as capital distributions and capital positions will be scrutinized on a rolling basis rather than annually.

Editor's Note: The title of this blog post is a reference to the opening lyric of the 1988 hit "Fast Car" by Tracy Chapman

Sources:

Barclays Equity Research, Stress Test 2020, June 26, 2020

Board of Governors of the Federal Reserve System, Assessment of Bank Capital during the Recent Coronavirus Event, June 2020

Board of Governors of the Federal Reserve System, Dodd-Frank Act Stress Test 2020: Supervisory Stress Test Results, June 2020