What Could Go Wrong in the Fed’s Stress Tests

Banks should fare well in this week’s Federal Reserve stress tests, but there are risks

By Aaron Back

Investors are looking forward to a stress-free round of bank stress tests this week. But there could be complications.

The Federal Reserve will reveal on Thursday which of the 34 banks it tests have passed hypothetical negative scenarios while maintaining required capital levels. Then next week it will say whether it has approved their plans to return capital to shareholders, a higher bar.

Last year every bank subject to the test passed, and all but two got the nod for their capital payouts. Investors expect another positive outcome this year. Going into the tests, banks over all have higher capital levels and better earnings prospects than last year. Analysts figure that Citigroup and Morgan Stanley could be in a position for the first time to pay out more than 100% of their projected profits.

Compared with last year, this year’s test assumes a slightly more severe domestic recession. Notably, it features a sharper decline in commercial real-estate prices—35% versus 30% in last year’s tests. Multifamily properties are assumed to suffer even bigger declines.

This means regional lenders with big commercial real-estate portfolios are probably at greater risk of failing. In a report, analysts at Goldman Sachs pointed to Key Bank, M&T Bank and Zions Bancorp as having the highest ratios of commercial real-estate exposure to risk capital.

For investors, the more important results will be next week when the Fed says how much capital banks can pay out. In an era of slow growth and low rates, bigger dividends and stock buybacks would be important drivers of bank shares. Even if these regional lenders do pass the first round of the stress tests, and that is likely, if their capital levels come close to regulatory minimums in the ugly scenarios, the banks may scale back their payout requests. That could hurt their stocks.

Some investors are also concerned that Wells Fargo could have its return plan denied on “qualitative” grounds as part of the extended fallout from last year’s account-sales fiasco. But Goldman’s analysts figure this is unlikely given the amount of work the bank has done to reform its sales practices.

The most likely scenario is still that banks will pass this year’s tests easily. But these few names are the ones to watch for potential surprises.

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