The results of the Federal Reserve's Dodd-Frank Act Stress Test (DFAST) showed that all 23 of the largest U.S. bank holding companies (BHCs) that participated in the test have capital levels well above their new required minimum levels. In aggregate, the banks' common equity tier 1 (CET1) ratio declined from 13% in fourth-quarter 2020 to a minimum of 10.6% under the Fed's stress scenarios, before rising to 11.2% at the end of the nine quarters of stress (first-quarter 2023). The 2.4% decline in the aggregate CET1 ratio in DFAST 2021 was slightly larger than the 2.1% decline in last year's June test, due in part to lower projected preprovision net revenue (PPNR), resulting from a flatter yield curve and a larger share of low-yielding assets on bank balance sheets. Per the Fed's guidance, banks are no longer restricted from returning excess capital--which we define as the amount of capital above their minimum capital requirement inclusive of a 50 basis point (bp) buffer--to shareholders beginning in third-quarter 2021.

Table 1

We estimate that in the aftermath of the test, U.S.-domiciled banks that participated in this year's test have roughly $175 billion of excess CET1 capital. However, we don't expect banks to reduce capital by nearly that much. First, because the impact of the pandemic has not played out fully yet, some banks may be cautious and maintain a buffer against potential losses once forbearance and deferrals have been phased out. Also, some banks' targeted capital levels are above their minimum required levels. In addition, bank management teams need to weigh other uses of capital, inclusive of a possible increase in loan demand, the pursuit of acquisitions, and internal capital needs to build out businesses/technological capabilities. Some banks are also more constrained than others by leverage-based capital ratios rather than risk-based capital metrics; need to keep an eye on a possible increase to their global systematically important bank (GSIB) buffer, which would take effect in 2023; and the possibility that their performance in next year's test could be worse than this year's. For those reasons, many banks maintain buffers greater than 50 bps.

From a rating standpoint, most of the U.S. banks tested have a risk-adjusted capital (RAC) ratio in the upper band of the 7%-10% ratio we consider adequate (meaning neutral to the rating). Many of our ratings already incorporate an expectation of some reduction in capital ratios after the significant rise that occurred during the pandemic and after regulators restricted payouts. As such, we don't believe the possibly higher capital return will affect our ratings. Still, for those banks that opt to swiftly reduce their capital ratios beyond our expectations, particularly if idiosyncratic risks remain outstanding, or if these banks have a particularly high rating versus peers, we would view this negatively from a credit standpoint and may take a negative rating action accordingly.

The Stress Capital Buffer Is Front And Center In Determining Banks' Possible Capital Return

A bank's stress capital buffer (SCB) is calculated as the difference between its starting and minimum CET1 capital ratios under the severely adverse scenario in DFAST, plus four quarters of planned common stock dividends as a percentage of risk-weighted assets (RWA). When computing the SCB, the Fed assumes that banks maintain a constant level of assets over the planning horizon. The floor for a bank's SCB is 2.5%, even if actual stress test results point to a lower ratio. The SCB was finalized in March 2020 and implemented in October 2020 (see Credit FAQ:"The Fed's New Rules Change Capital Management Dynamics For U.S. Banks", March 19, 2020).

Although last June's stress test was the official kickoff of SCB, its impact on capital management was somewhat muted because regulators had limited shareholder payouts and, as a result, capital ratios continued to rise. Specifically, banks were restricted from shareholder repurchases and from raising their dividends (though they could still pay dividends as long as they had enough income under a Fed formula). In December 2020, the Fed ran a second stress test incorporating scenarios to better reflect economic conditions that arose due to the pandemic. In the aftermath, the Fed left in place its restriction on dividend increases but eased its prohibition of share repurchases. Specifically, the Fed allowed shareholder payouts (the sum of dividends and share repurchases) up to an amount equal to each bank's average net last four quarter net income. But starting in third-quarter 2021, these restrictions will be lifted, and the SCB effectively will determine the extent of capital return. As long as a bank's capital ratio exceeds its minimum, inclusive of the SCB, it can return capital.

In table 2 below, we provide our estimate of the SCB for each U.S.-domiciled bank that participated in this year's stress test. The Fed should provide each bank's official SCB at a later date. Notably, under the tailoring rule, category IV banks (those with $100 billion to $250 billion in assets) had the option to skip this year's stress test. All chose to do so except for BMO Financial Corp., MUFG Americas Holdings Corp., RBC US Group Holdings LLC, and Regions Financial Corp. These banks likely opted in to try to improve their results from the previous year's test and add some flexibility regarding their capital return. The SCBs of banks that opted out will remain the same as calculated under the June 2020 test (see "The Fed's Latest Stress Test Points To Limited Bank Capital Returns," June 30, 2020 for these banks' SCBs.)

A few things to note for U.S.-domiciled banks from this year's results:

• The SCB declined for six banks (Capital One, Goldman Sachs, JPMorgan, Morgan Stanley, Regions Financial, and Truist) with Capital One and Regions showing the largest decline, largely due to lower provisions.
• Compared to the June 2020 test, the SCB rose for two banks (Citigroup and Wells Fargo), largely reflecting lower PPNR.
• All banks' current capital levels are above their new required minimum capital levels.
• We estimated that cumulatively the banks have roughly $170 billion of excess CET1 capital (assuming each bank opts to keep a 50 bps buffer above its minimum required level).
• Banks can return excess capital to shareholders according to their capital plan submitted to the Fed; they also have the flexibility to return more capital than their submission, if they wish to do so.

Table 2

The Supplementary Leverage Ratio Figures Into The Extent of Capital Return

The risk-based capital ratios--those tested in DFAST--may not be the binding constraint for some banks. Instead, for some, due to the robust growth in bank balance sheets, it may be the supplementary leverage ratio (SLR). Bank balance sheets have grown during the pandemic largely as a result of a large influx of deposits, largely due to monetary policy easing.

Last year, in an effort to ensure the sustainability of bank lending capacity, the Fed eased the calculation of the SLR, enabling the largest banks to exclude Treasury bonds and cash parked at the Fed from the calculation. This helped lift SLRs at the holding company by about 100 bps, giving bank SLRs ample room above the 5% minimum required at the holding company level. But earlier this year, the Fed announced that starting in the second quarter, banks will need to include Treasury bonds and excess cash at the Fed in their SLR calculation. (Note: the trust banks--Bank of New York Mellon and State Street--are still able to exclude cash at the central bank from their SLR calculations.) As chart 1 shows, with the revision to the calculation, the SLRs of the eight GSIBs fell a median of 90 basis points. If SLRs fall further it could limit shareholder payouts. With the Fed still purchasing securities, balance sheet growth may further weigh on SLRs.

Chart 1

Separately, the GSIB buffer, which is incorporated in banks' minimum required capital levels, may rise for some banks starting in 2023. Specifically, based on year-end 2020 data, the GSIB buffers for Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan, and State Street may increase by 50 bps if they aren't able to reduce their balance sheets in time.

Ranking The Banks According To The Stress Test

One useful analytical exercise in the aftermath of the stress test is to rank the entities by the extent of their capital decline without taking into account the banks' subsequent capital payout. We look at a bank's starting CET1 ratio and its minimum CET1 ratio during the nine quarters the stress test reviews, starting at the end of fourth-quarter 2020. The smaller the "burndown," or decline from the beginning ratio to the minimum ratio, the stronger the bank's capital and earnings position is relative to its risk, according to the Fed's stress test.

A few things to note for the U.S.-domiciled banks:

• The biggest improvement in terms of burndown from last year's test is Capital One, with a 320 bps improvement (likely due to the significant buildup of its allowance). Regions Financial also showed marked improvement of 150 bps.
• Eight banks' capital burndown worsened from last year's test (Bank of America, Bank of New York Mellon, Citigroup, Northern Trust, PNC, State Street, U.S. Bancorp and Wells Fargo), although most of these banks' SCBs still remained at the minimum of 2.5%.
• The largest capital burndown for U.S.-domiciled banks is Goldman Sachs, followed by Morgan Stanley. Still, both banks' burndown improved from the June 2020 test.

Table 3

Loan Loss Rates By Bank

The Fed projected that, in aggregate, the banks would experience $474 billion in losses on loans and other positions over the nine quarters of the projection horizon, with $353 billion in loan portfolio losses. This equates to a nine-quarter cumulative loss rate of 6.2%. This is about the same as last year's rate, with individual bank loss rates this year ranging from 1.5% to 12.8%. In table 4 below, we show aggregate loss rates by loan type with an individual bank's loss rate for that type of loan while also noting whether this loan type is sizable (more than 10% of loans), which could point to riskier lending than peers.

Table 4

We Use Stress Tests To Predict Capital Return, Which Has An Impact On Ratings

Although the stress test does not figure directly into our ratings, we use the results of the test to help forecast capital return to derive our projected RAC ratio, which is an integral part of our rating process. We also focus on burndown analysis (as depicted above) and loan loss rates to see if any banks are outliers to our own independent credit review. Additionally, large differences between a banks' internal stress test results also informs our view as we assess a bank's risk score. (The banks publicly release results of how they performed in an internal stress using the Fed's parameters.)

All in all, we believe the relative strength or weakness of the banks based on DFAST burndown analysis and loan loss rates is in sync with our ratings--but not perfectly in sync. For example, we take a more negative view of a lack of revenue diversification by location or business, which is not figured directly in the stress test. In addition, our ratings on foreign banks domiciled in the U.S. are not comparable to the Fed's assessment, because we incorporate the likelihood of support from the consolidated entity to derive our rating, while the Fed looks only at a stand-alone assessment of the entity's riskiness.

Appendix

Key assumptions in this year's severely adverse scenario were largely similar to last September's stress test scenarios  

• Unemployment reaches 10.75%, a four percentage point increase relative to Q42020.
• GDP declines by 4% and inflation declines to 1%.
• Stocks decline by 55%.
• Three-month U.S. Treasury rates falls to near zero while the 10-year falls to 0.25%, gradually rising to 1.5%.
• Conditions in corporate and real estate lending deteriorate markedly.
• Home and commercial real estate prices decline 23.5% and 40%, respectively.
• There are severe recessions in the euro area, U.K., and Japan, and a shallow recession occurs in developing Asia, with the U.S. dollar strengthening against major currencies except the yen.
• A global market shock to the trading portfolios of eight firms with the largest trading and private equity exposures (Bank of America Corp., Bank of New York Mellon Corp., Citigroup Inc., The Goldman Sachs Group Inc., JPMorgan, Morgan Stanley, State Street, and Wells Fargo).
• A counterparty default scenario component for these eight banks, with substantial trading, processing, or custodial operations. It includes the instantaneous default of the bank's largest counterparty.

Restrictions if a bank falls below its SCB requirement 

A bank whose capital ratios are at or below its minimum (4.5%) plus its SCB requirement and any applicable GSIB surcharge and countercyclical buffer would be subject to automatic restrictions on capital distributions on a sliding scale (based on the extent of the breach) based on its eligible retained income.

Related Criteria

• Group Rating Methodology, July 1, 2019
• Risk-Adjusted Capital Framework Methodology, July 20, 2017
• Banks: Rating Methodology And Assumptions, Nov. 9, 2011

Related Research

• Various Rating Actions Taken On Large U.S. Banks And Consumer-Focused Banks Based On Favorable Industry Trends, May 24, 2021
• The Fed's Stress Test Results Open The Door For U.S. Banks To Increase Capital Returns In 2021, Dec. 22, 2020
• The Fed's Latest Stress Test Points To Limited Bank Capital Returns , June 30, 2020
• Credit FAQ: The Fed's New Rules Change Capital Management Dynamics For U.S. Banks, March 19, 2020
• The U.S. Banking Sector Should Remain Stable Despite Easing Regulatory Oversight, Oct. 22, 2019
• Most Banks Breezed Through The Fed's Stress Test--And Can Now Return Significant Capital To Shareholders , July 1, 2019