All 23 U.S. banks involved in the recent stress test by the Fed have proven their mettle, enduring an imaginary severe global recessionary scenario. The test took into account an unemployment jump of up to 10% and a stock market plunge of 45%. The annual stress tests, established following the 2008 financial crisis, help banks to evaluate how much capital they require to weather economic shocks. These results impact the banks' decisions on dividends and buybacks.

Results revealed that these financial institutions would have sufficient capital to contain losses and continue operations. The total projected losses under this severe scenario would amount to $541 billion. Large U.S. banks such as JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley topped the Fed’s 4.5% minimum capital buffer requirement.

Variability in Results

Despite the general firmness in the sector, results varied widely across the industry. Charles Schwab boasted the highest capital ratio under the Fed’s “severely adverse scenario,” while Citizens Financial, a Rhode Island-based regional bank, had the lowest.

Other regional banks like US Bancorp and Truist passed the test with lesser buffers compared to their big-sized brothers. The rate of total loan losses varied considerably across banks, from a low of 1.3% at Charles Schwab to a high of 14.7% at Capital One.

Large financial institutions also displayed considerable projected net income losses under the adverse scenario, with Citigroup leading at $34.9 billion, followed by Wells Fargo and JPMorgan. However, banks are also preparing for a new set of higher capital requirements from the Fed.

These rules will need some banks to hold even larger buffers against losses. Though the regulations look to restore the stability of these institutions, they might find it difficult to generate solid profits and limit certain types of lending.

As part of its active measures, the Fed is exploring "reverse stress testing" as a tool to improve banks' resilience. This testing method can help supervisors find out the likely issues that might have been overlooked by traditional approaches.

Regional Banks to Feel the Pressure?

The recent Federal Reserve stress test showed regional banks, including U.S. Bank, Truist, Citizens, M&T, and card-centric Capital One, experiencing a notable drop in capital levels amid a hypothetical recession, falling from 12.4% to 10.1%. These banks, which are significantly exposed to commercial real estate and credit-card loans, witnessed stress capital levels hovering between 6% and 8%.

While these levels are above the current standards, they could create difficulties if imminent regulations impose higher capital requirements. With the expected regulatory changes and recession risks, banks are expected to disclose conservative capital plans for buybacks and dividends.

ETF Impact

Although most bank ETFs should jump higher in the near term as all banks cleared the stress test, the regional bank rally may lose steam over the long term. Regional bank ETFs like SPDR S&P Regional Banking ETF (KRE Quick QuoteKRE - Free Report) and iShares U.S. Regional Banks ETF (IAT Quick QuoteIAT - Free Report) could be good bets for the near term (especially given the cheaper valuation) but large bank ETFs like Invesco KBW Bank ETF (KBWB Quick QuoteKBWB - Free Report) and Financial Select Sector SPDR Fund (XLF Quick QuoteXLF - Free Report) should fare better over the long term. This is especially true given that the Fed is likely to hike rates again and the crisis is not over yet for regional banks.