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Morningstar | 2019 DFAST Results Better Than Last Year, and We Expect No Capital Return Surprises Next Week

The U.S. Federal Reserve released the 2019 results from the Dodd-Frank Act stress tests, or DFAST, that serve to inform regulators, financial markets, and the general public how institutions' capital would withstand a hypothetical set of adverse economic conditions. All 18 of the banks subject to the stress tests this year performed adequately on the most commonly watched measure, the common equity Tier 1 capital ratio. Results were better than last year, with lower average loss rates, better average stressed Tier 1 ratios, and no banks falling below 6% (Capital One did fall to 6%, but not below). As such, given the steady results this year for the banks, we would expect no negative surprises when it comes to the capital return plans of the U.S. banks we cover. With many banks still looking to release a bit more capital, payout ratios at or above 100% should not be uncommon, although many of the banks are getting closer to the Tier 1 targets they have set out to meet, so some payout ratios should be in the mid-80s to high 90s. We are maintaining our fair value estimates and economic moat ratings for the banks.

Overall, Wells Fargo still likely has the most capital to release, and should be going into the Comprehensive Capital Analysis and Review stress tests with a pretty big ask, especially considering the firm still cannot grow its balance sheet. If we assume Wells can get at least $30 billion in capital returns approved (just below last year), and roughly $8.3 billion of that goes toward dividends (about 40% dividend payout ratio and 5% dividend growth), the bank would have enough capital left over to repurchase over 10% of its market cap, and, all else equal, this would get it roughly halfway to the high end of its updated Tier 1 target of 10.5%. Citigroup is also still holding a good amount of excess capital and has $20 billion remaining in its $60 billion three-year plan. If we assume a 20% increase to the dividend, which would result in a slight drop in the projected payout ratio, roughly $15 billion in capital would be left over to repurchase shares, or just under 10% of Citigroup’s current market cap.

Because of regulatory reforms for the industry, banks with less than $100 billion in total assets were already no longer subject to both the DFAST and CCAR stress tests, even in the 2018 cycle. Therefore, CIT Group, Comerica, and Zions remained off of this year’s tests. New for this year, banks with between $100 billion and $250 billion of assets were also exempt (from our coverage list: Huntington Bancshares, M&T Bank, Regions Financial, KeyCorp, Fifth Third Bancorp, SunTrust Banks, BB&T, American Express, Discover Financial Services), as they are now on a two-year cycle. The effects of tax reform were not in this year’s test, which was actually a negative for the banks last time with regards to stress testing, so this was an easing factor for the tests. The severely adverse scenario was also easier in several regards, providing further relief. We are waiting on final approval of the Stress Capital Buffer, as well as further clarification and approval around more “tailoring” rules, which could change current capital levels and the stress tests going forward.

The Fed uses two stressed scenarios, adverse and severely adverse, as part of its tests. Highlights of the severely adverse scenario include a severe global recession, with real U.S. GDP hitting a peak decline of 8% (versus 7.5% last year), the U.S. unemployment rate rising to 10% (same as last year), equity prices falling 50% (versus 65% last year), house prices falling 25% (versus 30% last year), and commercial real estate prices falling 35% (versus 40% last year). On average, the aggregate common equity Tier 1 capital ratio would decrease to 9.2% from 12.3% in the fourth quarter of 2018 in the severely adverse scenario. This was better than last year's fall to 7.9%. Overall, the tests this year were less severe.

Next on the calendar for the Fed is the June 27 release of the CCAR results, which take into account each company's capital plans, such as dividend payments, stock repurchases, or planned acquisitions, along with a qualitative assessment of the bank’s capital planning process (although the qualitative objection has been dropped for the majority of the banks at this point). The Fed essentially evaluates whether each bank would still pass the stress test even after planned capital releases. It is also around this time that the banks begin disclosing what their capital return plans are for the next 12 months. Given the steady results on DFAST this year for the banks, we expect no surprises here.