The U.S. banking sector is bracing for the 2024 stress test results, scheduled to be released Wednesday after the market closes.

Bank of America analyst Ebrahim H. Poonawala expects this year’s stress test to show overall improved capital buffers compared to 2023, given the moderately better severely adverse scenario outlined by the Federal Reserve.

Improved Capital Buffers Expected

According to Poonawala, banks are entering the 2024 stress test with approximately 300 basis points (bp) of excess Common Equity Tier 1 (CET1) capital above regulatory minimums, a notable increase from around 185 bp last year.

“Surprises from the annual stress test results are inevitable given the inherent opacity, but we expect these to be manageable,” Poonawala stated.

The improved capital position would imply a better ability to absorb an increase in the stress capital buffer, which is a positive development as banks navigate real-life challenges posed by the current macroeconomic backdrop and changing regulatory attitudes.

Bank Stress Test’s Severely Adverse Scenario

The 2024 stress test’s four scenarios, designed to provide the Federal Reserve with insight into the resiliency of the U.S. banking system, focuses on funding stress and the failure of five large hedge funds.

In the Fed’s hypothetical severely adverse stress scenario, the Dow Jones Index is expected to fall 55%, the unemployment rate to rise by 6.3 percentage points to 10%, the VIX or fear index to spike to 75, and the residential and commercial real estate (CRE) markets to experience declines of 36% and 40%, respectively.

Poonawala noted, “We wondered if the Fed would inject a much steeper fall in CRE prices given the heightened focus on this asset class. CRE prices are expected to decline by 40% from start to trough, consistent with prior years (’18, ’21, and ’23).”

According to Bank of America, there is sensitivity to the potential for the Fed to emphasize certain issues, such as CRE, which could lead to unexpected outcomes.

Bank Stocks And ETFs To Watch

Bank of America is closely monitoring the performance of several banks, including the five new stress test participants: Ally Financial Inc. ALLY, Fifth Third Bancorp FITB, Huntington Bancshares Inc. HBAN, KeyCorp KEY, and Regions Financial Corp. RF.

“Banks that did not participate in last year’s stress test could potentially experience harsher loss rates given a worse outlook for GDP, unemployment rate, and CRE values vs. 2022,” Poonawala stated.

Other institutions of particular interest according to Bank of America are Goldman Sachs Group Inc. GS, Citigroup Inc. C and M&T Bank Corporation MTB.

With a 90 bp decline in stress-test capital buffers (SCB) from 2023 to 2021, driven by reduced exposure to private investments, Goldman Sachs may see continued relief and capital optimization. “Lower CET1 req. should be viewed positively, supportive of stock momentum,” Bank of America wrote.

Citigroup would also benefit from a lower CET1 requirement since it could facilitate increased share buybacks over the next year.

With the highest exposure to CRE loans and approximately 250 bp of excess capital above regulatory minimums, M&T is managing towards an 11% CET1 target.

Last year, the bank index closed 1.8% higher (compared to 0.4% for the S&P 500) following the stress test results. Banks that saw a decline in their SCBs rose by 2.6%, those with unchanged SCBs increased by 1.1%, and those with higher SCBs gained 0.4%. This year, investors will be keenly watching for similar trends.

“Last year banks where the SCB declined, outperformed the bank index (BKX) by 80bp on average the following day and by 220bp vs. those that saw their SCBs rise,” Poonawala wrote.

Three banking-related ETFs to keep an eye on this week are: