What the Stress Test Results Mean for Banks
Capital returns are coming back, but don't forget about valuations.
The Federal Reserve Board recently released the results of its 2021 stress tests of 23 large U.S. banks. The tests showed the banks easily maintaining adequate capital ratios in a severe economic downturn, and the Fed lifted its capital return restrictions as of June 30. Repurchases and dividend growth are coming back for the banking sector, but we advise investors to think beyond a simple capital return thesis. Valuations matter, no matter how much excess capital any bank has. We see several banks with outsize opportunity for share repurchases but few bargains from a valuation perspective. We think it pays to be selective in the current environment.
Overall, with stress scenarios generally within the range of what we’ve seen in the past (even slightly less harsh in some aspects), and with the banks heading into the 2021 cycle with excess capital and reserves, it was unsurprising to see the banks pass this year’s tests with ease. No bank received conditional approval or had to resubmit anything, and none of the banks came close to breaching minimum capital requirements.
The banks entered this year’s tests with excess loan-loss reserves and higher common equity Tier 1 ratios. As a result, minimum common equity Tier 1 levels were generally higher than in years past. This is something we would expect to come back down next year as banks return capital and bring down their common equity Tier 1 levels, which are currently higher than normal.
Higher loan-loss reserves meant that the banks had to provision less, relative to overall loan losses, than in the past. This is also something we would expect to normalize next year. Loan-loss rates were generally comparable with last year, although the regulators intentionally stressed commercial real estate portfolios more this year compared with the June 2020 tests. Card loss rates declined a bit, which was an interesting development that benefited Capital One (COF) the most.
Going into this year’s tests, we projected that dividend payout ratios were going to start trending toward the higher end of recent ranges, driven by reduced profitability due to lower interest rates. As such, we expected only moderate dividend growth in the mid-single-digit to high-single-digit percentage range on average (with the exception of Wells Fargo (WFC), where a doubling looked reasonable). Some banks have come out with dividend announcements above our expectations, but overall, dividend growth is going to be 11% or less for 7 of the 12 participants that we cover, while the higher growth for Wells Fargo and Capital One was predictable as both banks bounce back from dividend cuts. We expect dividend payout ratios to remain slightly elevated for some until interest rates rise, but all payout ratios still look very reasonable to us.
Without rate hikes, we don’t see massive earnings growth for most of our banking coverage. There are some levers that could still go in certain banks’ favor, such as balance sheet growth (particularly for harder-hit card-focused banks) or growth in fee income streams such as wealth management, but overall we don’t expect massive earnings growth after 2021 for most of our coverage. In fact, we see earnings retreating for most as reserve releases fade and as fee items that have done exceptionally well, such as trading, come back to earth.
We do not expect a lot of room for massive dividend growth in 2022, either. Most banks that announced dividend hikes (other than Capital One and Wells Fargo) announced growth of 10% or less compared with double-digit growth for most in the 2018 and 2019 Comprehensive Capital Analysis and Review cycle. We currently expect 2022 to look similar to 2021, with dividend growth capped at 10% or less for most players.
We’ve run a hypothetical scenario using our own underlying net income projections. We also use any available 2021 dividend announcements, but otherwise we assume 5% dividend growth everywhere else and in each year after 2021. We assume each bank uses up excess capital over 2021 and 2022 for share repurchases. We also assume the rest of net income in 2021 is used up for share repurchases, while assuming 20% net income retention for organic growth in 2022 and 2023, with the rest being used for share repurchases. Using these assumptions, we can model what hypothetical dividend payout ratios might be under this 5% dividend growth baseline. In most cases, even with 5% dividend growth assumed in 2022 and 2023, payout ratios are about where we would expect them to be and in some cases are even a bit elevated. In a few cases, such as Bank of America (BAC), Regions Financial (RF), M&T (MTB), and Capital One, there might be some room for additional dividend growth. We think banks will rely on rising rates for any outsize wave of dividend growth going forward.
Banks have more flexibility in their capital planning under the stress capital buffer framework. While banks still submit capital plans to regulators, they are allowed to deviate from these plans without seeking additional regulatory approval (in most situations), as long as their capital ratios stay within the regulatory guidelines. As such, we did not expect to see the same number of share-repurchase announcements this year. These expectations have proved correct, as only 4 of the 12 participating banks that we cover announced official repurchase plans in response to the stress test results. Several said they would give more details on their second-quarter calls, while several others simply stuck to already existing repurchase plans without providing additional details.
We calculate that Wells Fargo and Capital One have the most excess capital to release among the banks that participated this year. On the basis of new announcements or existing repurchase plans, most participating banks don’t seem to have called out enough repurchase capacity to cover their excess capital and expected available net income over the next four quarters. This isn’t a problem, since banks now have the flexibility to buy back as many shares as they want without seeking new approvals (as long as their capital ratios stay within regulatory guidelines). Rather, we think it’s likely that these banks could increase their repurchase amounts as the year progresses, if all goes well. We also don’t think Goldman Sachs (GS) will end up using all of its existing program of 41 million shares over the next 12 months.
The banks we cover generally have excess capital that is 1 to several percentage points of their existing market capitalization. This should allow for payout ratios above 100%, depending on when and to what extent asset growth re-emerges and each bank’s internal investment needs.
If we assume that loan growth starts to resume and that risk-weighted assets grow 5% across the board (it could be higher than this for traditional banks if loan growth really does start to come back), then the field of banks with excess capital becomes more selective. Wells Fargo, Capital One, Discover (DFS), and Morgan Stanley (MS) stick out to us as the ones with the most outsize opportunity for share repurchases, even with growing balance sheets. Under this simulation, these four are the only banks that could still repurchase 10% or more of their shares; 17 of the 23 banks we cover have 3% or less of market cap in excess capital.
We think it’s realistic that Wells Fargo and Capital One could repurchase 10% or more of their shares this year, while we think Discover has the capacity to repurchase 12%, which is close enough to 10% that it could get cut down to 10% or less depending on how the year plays out. Morgan Stanley and BNY Mellon (BK) both get close to 10%, with 9% repurchase capacity over the next 12 months. We think most other banks will be closer to repurchasing a mid- to upper-single-digit percentage of total shares over the next 12 months.
While dividend growth and share repurchases are set to resume following a turbulent 2020, we think investors need to think beyond theses built solely on share repurchases. Ultimately, repurchases create the most value when they are done with shares that are undervalued; they create little to no value if shares are fairly valued or overpriced. With the recent run the whole sector has had, we think investors need to keep valuations in focus.
On average, we see our coverage as fully to slightly overvalued today. While opportunity is more limited today than it was last year, we still see some names as undervalued. Huntington Bancshares (HBAN) is the most undervalued name on our banking coverage list. It trades more than 20% below our fair value estimate with a merger catalyst (the acquisition of TCF Financial) that has just started to play out. We think that cost savings and steady performance during this lower-rate environment will eventually demand a better valuation. Wells Fargo also remains undervalued, at a nearly 20% discount. We expect that the asset cap will be lifted sometime in the fourth quarter of 2021 or first quarter of 2022, which will be a catalyst for further upside. The bank also remains one of the most sensitive to higher rates. In addition, it has an above-average ability to repurchase shares. While the repurchasing of shares on its own does not make a full thesis for Wells Fargo, we think it helps support all the other aspects of our thesis for the bank.
We’ll also call out Capital One, which is trading 10% above our fair value estimate. The bank has one of the highest capacities for share repurchases among our coverage, but we don’t see those repurchases adding a lot of value at today’s prices.
With regard to the custody banks, we find BNY Mellon more attractive than peers State Street (STT) and Northern Trust (NTRS). We believe that BNY Mellon’s diverse set of businesses help limit downside and note that it has areas of growth such as its register investment advisor custody business. In addition, BNY Mellon has the most to gain if short-term interest rates rise, given its money market business.
Eric Compton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.