Alex Cho
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Buy Banks After Dodd Frank Act Stress Test?

The Federal Reserve conducted the Dodd Frank Act Stress Test (DFAST) a couple days ago, which gives us somewhat better visibility on CCAR (comprehensive capital analysis and review) results, which differ from DFAST.

That being the case, virtually every bank passed through the DFAST with reasonable results, which puts the financial sector universe in a relatively strong position to return capital, but it doesn’t really do a whole lot for investors given the broad weakness in financial sector names in response to Brexit.

That being the case, here’s what RBC Capital Markets mentioned in response to DFAST results:

In general, DFAST stress tests differ from CCAR stress tests in that DFAST has a standardized set of capital action assumptions where dividend distributions are held at the same level as the previous year and there are no common share repurchases. CCAR capital action assumptions, however, are based on each company’s planned capital actions. Results for CCAR will be released on June 29th, 2016 at 4:30 PM EDT.

So, what about the data?

Well, according to Credit Suisse the Federal Reserve was pretty conservative on DFAST stress test when compared to their own estimates, but the results could be broadly interpreted as better than expected with some firms provisioning better for credit losses and asset write down in an adverse scenario. That being the case, the specific figures weren’t necessarily alarming on the PPR (pre-provisioned revenue), which is supportive of capital return plans for both G-SIFI and Trust Banks.

Here’s what was mentioned by Credit Suisse:

Relative to the forecasts of the companies in our coverage, the Fed forecast 41% more PPNR, but 6% less net income before taxes, with 12% higher ending RWAs versus those firms' forecasts. See Figure 12. Recall that in DFAST 2015, the Fed also imposed more conservative assumptions with respect to RWAs (8% above the firms' forecasts), but had also forecast a higher level of stressed PPNR (see Appendix 3).

So, the risk-weighted asset figure is a little alarming, but I believe much of this was in response to weakness in the energy and industrial space, which have been weak from both a macro and commodity pricing basis, as below investment grade debt in those spaces are likely to see higher default rates, which is in-line with the observations that I was able to gleam from the credit rating agencies like Standard & Poor’s.

Source: Deutsche Bank

Now, from my understanding, there were pretty material differences between Deutsche Bank’s base case, and the stress case scenario from the Federal Reserve. That being the case, the base case from Deutsche Bank is a little more in-line with current market conditions whereas the stress case from the Federal Reserve implies substantial random occurrence in recession probabilities, and implies a scenario of around 5-6% GDP contraction, which is unlikely. As such, the difference in financial estimates from sell side analysts and the Federal Reserve is usually wide, with DB est. roughly 35% higher on pre-provisioned net revenue (excl. taxes) and 1.6% higher on net income before taxes. But, notwithstanding these discrepancies, as implied earlier by other analysts, the figures were relatively solid and does create a pathway for accelerated capital returns once the major banks are able to stabilize CET 1 ratios to meet fully phased in 2019 Basel 3 requirements.

As such, there’s not a whole lot of negative news on the capital return front for the major/regional banks in North America. I do anticipate CCAR results to differ from DFAST, but it’s not going to lead to material variances in observations despite the qualitative differences in both stress test scenarios. In other words, financial sector dividend/capital returns should still remain robust despite volatility pertaining to Brexit, as the vast majority of economists are readjusting U.S. GDP estimates to the tune of 10 to 20 basis percentage points, which isn’t a strong enough of an economic signal to derive meaningful variances in the Fed’s GDP/inflation/unemployment/interest rate outlook.

As such, the major banks still carry merit, but investors should be selective and focus on high-quality franchises like JPMorganChase and Bank of America.