$ 153 billion in assets Financial regions (NYSE: RF), based in Alabama, opted for this year’s annual stress tests, although it wasn’t necessary. Each year, the Federal Reserve subjects the largest banks in the United States to a set of what-if economic scenarios to ensure they could survive a severe recession and continue to lend to individuals, families and businesses. While banks with more than $ 250 billion in assets are stress tested every year, banks with between $ 100 billion and $ 250 billion in assets only need to pass stress tests once every year. two years. And despite the Fed’s multiple stress testing cycles last year, regions have chosen to do it again this year. Here’s why.

Stress capital cushion

Stress tests are extremely important for big banks every year because they ultimately determine how much capital they will need to hold relative to their risk-weighted assets, such as loans. Banks would prefer to be able to hold less capital because any capital they need to hold does not earn any kind of return, which ultimately lowers their profitability.

The Fed arrives at the amount of capital a bank will hold by dividing it into three parts. There’s the lower 4.5% requirement that every bank has, and then there’s the relatively new middle layer called the Stress Capital Buffer (SCB), followed by the top tier, which only affects the eight institutions considered. as Global Systemically Important Banks (GSIBs). Together, the ratio of total capital held by a bank to its total risk-weighted assets is called the Tier 1 Common Equity Ratio (CET1), an important regulatory ratio that investors and regulators monitor closely. .

Image source: Federal Reserve.

Each bank, regardless of its size, must reserve capital equivalent to 4.5% of its risk-weighted assets. The SCB is determined by taking the difference between the starting CET1 capital ratio and the minimum required CET1 capital ratio projected for a given period under severe global recession conditions set by the Fed. Then the Fed adds four quarters of expected dividends as a percentage of risk-weighted assets to arrive at the total SCB, which is capped at 2.5%. Thus, a bank’s lowest CET1 ratio is 7% of risk-weighted assets.

Following the Fed’s stress tests at the end of last year, the Fed determined the regions SCB to be 3%. Almost all of the region’s peers scored 2.5% SCB, and regions had the highest SCB outside of Citizens’ Financial Group, which obtained an SCB of 3.4%.

Will the regions have a lower SCB?

Last year, the assumptions underlying the Fed’s hypothetical economic scenarios were quite severe. In a severely adverse scenario, unemployment would have peaked at 12.5% ​​at the end of 2021, then fell back to around 7.5%, while gross domestic product (GDP) would have declined by 3% between the third quarter of 2020 and the fourth trimester. from 2021.

In this year’s very unfavorable hypothetical scenario, unemployment in the United States would reach 10.75% in the third quarter of 2022, while GDP in the same period would fall by 4%, with stock prices falling by 55%. . It’s actually more severe on the GDP front, but less in terms of unemployment. Still, I imagine that if regions go through the difficulty of stress testing when it isn’t necessary, they think they have a chance to get back to SCB of 2.5%.

White-collar workers celebrating success together.

Image source: Getty Images.

Now, whether the bank gets a SCB of 2.5% or 3% will not change the way regions manage capital. At the end of the first quarter, the regions had a CET1 ratio of 10.3%, and management said it intended to keep CET1 somewhere between 9.25% and 9.75%. If the bank obtains the desired 2.5% SCB, its required CET1 ratio will only drop from 7.5% to 7%. But as Regional CFO David Turner said, “There’s no way in the world that our cash capital is less than 7%. I think as an investor, most investors would have conniption if we did this. ” On the contrary, Turner said the new SCB test was an opportunity to send a message.

When your peers are all below the 2.5% low and you are at 3%, it kind of sends the message that your credit quality is worse. We don’t believe that and we wanted a very public opportunity to demonstrate it. And that’s really what it was.

And the credit quality of the regions looks strong at the moment. The bank has set aside enough money to cover losses on 2.44% of its total loan portfolio, but does not expect to have net write-offs (debt unlikely to be recovered, a good representation of overall losses) 0.50% of its total loan portfolio. . In addition, the bank reduced its exposure to sectors heavily affected by the pandemic to 4.2% of average loans, and many of its loans in high-impact sectors performed well at the end of the first quarter.

What does it mean to have a lower SCB?

As Turner mentioned, having a lower SCB won’t really change the way the bank manages capital. But it could allow the bank to manage capital in the lower end of its internal range – closer to 9.25%, which opens up more room for share buybacks, dividends or acquisitions. But more importantly, it sends a message to investors that regulators view its credit quality the same as its peers. It could allay any doubts and extend what has already been a great race for action over the past year.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Questioning an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.