Bank Earnings

Real stress hurts bank takeovers more than the Fed test

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Jerome Powell submits major US banks to two stress tests. The Federal Reserve Chairman’s ruthless interest rate hikes are hitting asset values ​​hard, and that could prove painful for earnings in the second quarter and beyond. Share buybacks by most major banks are already slower this year than last as they face billions in losses on the government bonds they hold and potentially on underwritten debt transactions. for the customers.

Meanwhile, the just-released results of the Fed’s theoretical reviews of the crisis showed the big banks had enough capital to survive a severe shock. He ran through tougher scenarios than last year, including a bigger rise in unemployment and lower house prices. At the same time, the Fed has already asked JPMorgan Chase & Co., Citigroup Inc. and Goldman Sachs Group Inc. to build larger buffers next year to guard against the systemic risks they present.

And yet, for shareholders, the news is that dividends and redemptions in 2023 will likely still be extremely healthy. In forecasts made before the outcome of the Fed’s stress test, JPMorgan was expected to lead the pack with dividends and buybacks in 2023 totaling between $19 billion and $21 billion, according to estimates by analysts at Barclays and Jefferies. That’s well below 2021’s total of almost $30 billion, but it included withheld profits from 2020 at the height of the Covid crisis.

Bank of America Corp. and Wells Fargo & Co. are next, both forecast by Barclays to bring in a total of more than $15 billion and by Jefferies to bring in nearly $21 billion, again well below last year. Morgan Stanley follows, then Citigroup, and Goldman brings up the rear with payments estimated at $6 billion (Barclays) to nearly $8 billion (Jefferies). Banks can start presenting their capital plans next week.

Next year’s redemptions are likely to be better than this year’s, especially for large commercial depository banks. JPMorgan has already slowed share buybacks this year in part because of the decline in the value of Treasuries held on its books as interest rates rose. Executives from BofA, Wells and Citi made cautious comments about share buybacks during first-quarter earnings calls.

All four suffered billions in unrealized losses in the first three months of the year and are likely to do so again due to further Fed rate hikes. Yields on very short-term and very long-term Treasury bills rose more in the second quarter than in the first, but yields between two and seven years rose less. That should mean bank losses are less severe, according to Wells Fargo analyst Mike Mayo, who said movements in five-year yields are the best indicator. They could still amount to 2.5% to 3.5% of equity, he estimates.

For investment banks, there could also be big losses on the debt they’ve underwritten for companies, especially those involved in buyouts, as investor appetite has dried up. Some loans and bonds are being sold at steep discounts as Wall Street seeks to wipe risky trades off the books. For some, the saving grace will be strong profits from active trading in currencies, rates and commodity-related products. Citigroup, for example, expects trading revenue to rise 25% this quarter compared to results in the prior year period.

The sharp rise in interest rates to fight inflation underpins all of this and should boost commercial bank earnings through higher net interest income, even if it initially disrupts markets. Yet the shares of all those banks except Wells underperformed the S&P 500 index, showing investors are ignoring the banks’ lower risks and greater resilience, Mayo said.

The volatility of bank capital returns in recent years and the fact that regulators acted to restrict payouts during the Covid pandemic in 2020 raise questions about the value of stress testing. They are supposed to prepare banks for the worst so they can continue to make their own disaster capital decisions. Critics of the Fed’s tests, meanwhile, say they’ve been watered down so much under the loosening of rules by President Donald Trump’s administration that they’re ineffective.

The truth is in between: the tests are important for banks and regulators to exchange information, and they help set bank capital requirements appropriate to the actual risk they present in a reasonably transparent way. Bank executives will almost always say they have too much equity, but shareholders always reap great rewards. The lessons of previous crises are that regulators are right to err on the side of caution.

More writers at Bloomberg Opinion:

• Wall Street has a big buyout loan headache: Paul J. Davies

• US economy heading for hard landing: Bill Dudley

• Powell finally has markets where he wants them: Jonathan Levin

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.

More stories like this are available at bloomberg.com/opinion