The good news and the unknowns for bank stocks after the Fed's latest stress tests

Published Fri, Jun 30 20231:57 PM EDTUpdated Fri, Jun 30 20232:05 PM EDT

Club holdings Wells Fargo (WFC) and Morgan Stanley (MS) aced the Federal Reserve's stress tests, showing new signs of improved resiliency and fresh hopes for the continued return of excess capital to shareholders. All 23 of the U.S. banks included in the Fed's exercise passed with room to spare in their capital buffers. The annual health check aims to measure how financial institutions can withstand a severe economic downturn. This year's results, out late Wednesday, came just months after the collapse of Silicon Valley Bank in March, which touched off other regional bank failures and a mini-banking crisis. "Bank stocks had a good day [Thursday]. Understandable because this year's stress tests came against a backdrop of uncertainty for the sector. Markets certainly paid attention to the results by name," Nicholas Colas, DataTrek Research co-founder, told CNBC, adding "the next big event" will be when banks will announce plans for dividends and buybacks based on the tests. The Fed told banks to wait until Friday after the bell to announce any actions they plan. As for the results, JPMorgan, Bank of America, and Wells Fargo were the "big improvers here" in the 2023 stress tests, Doug Butler, director of research at Rockland Trust, told CNBC. "Citi was the worst of the big banks," he added, pointing to Citi's marginal stock gain Thursday while the others finished sharply higher. In Friday trading, Wells Fargo and Morgan Stanley added to their prior-session gains. The stress tests Starting in the aftermath of the 2007-2009 Great Financial Crisis, bank stress tests were designed as a tool to ensure that so-called too-big-to-fail institutions could endure a similar calamity. Essentially, they hold firms accountable to manage themselves as if the next recession were always just right around the corner. These tests also give investors insight into how much excess capital the sector can be returned to its shareholders via dividends and buybacks. The tests subject banks to a worst-case scenario that was more extreme than last year. Firms endured a hypothetical "severe global recession" where unemployment surged to 10%, home prices declined 38% and commercial real estate values plunged 40%, according to the Fed. Despite that stimulated painful climate, banks largely performed better than in 2022. The good news Results indicated that Wells Fargo and Morgan Stanley can get by with lower stress capital buffers, which basically assess how much capital a bank has after factoring in losses in a stressed scenario plus the pre-funding of four quarters of dividends, with a 2.5% floor. The regulatory minimum ratios on Common Equity Tier 1 (CET1), which account for a bank's liquid assets, declined at both banks as well, reinforcing the idea that both have strong capital positions with excess money to return to shareholders. WFC MS YTD mountain Wells Fargo vs. Morgan Stanley YTD performance It's worth noting that Wells Fargo is in a unique situation compared to its rivals. In 2018, the Fed announced an enforcement action on Wells Fargo that caps the firm from managing over $1.9 trillion in assets. We believe the timing of a Fed decision to lift the asset cap as a when, not if scenario, which would allow the bank to increase its balance sheet and generate more profits. The unknowns Following the collapse of SVB and other regional lenders, regulators are watching the financial resiliency of Wall Street even closer. However, the Fed stress test was not updated to factor in rising interest rate risks, which was one of the factors that played into SVB's failure. "The headlines are correct in that the tests showed that larger banks have sufficient capital to handle an economic shock. Two caveats, though. The first is that regionals fared less well, and they have been under increased scrutiny lately because of SVB," Colas said. He added that the "stress tests only really address a macro environment where rates decline during a crisis. There is no stress test for an inflation shock that pushes rates higher and the economy lower." Financial regulators may soon clamp down further on the banking sector. According to a Wall Street Journal report earlier this month, rule changes could require major banks to hold as much as 20% more capital. In theory, this could be negative because banks may lend less, eating into revenue streams like fees. Chris Kotowski, senior research analyst at Oppenheimer says that if implemented, big banks would likely adjust to tightening regulation. "Banks will adapt to capitals over time, but if there's a sudden increase in capital requirements, you know, in the quarter or two or a year after, they can't necessarily adjust to that instantly, but they will adjust," Kotowski told CNBC. "If the capital charge on a certain kind of trading inventory is suddenly 20% more, all the market makers in that trading category are going to want to hold 20% less capital." (Jim Cramer's Charitable Trust is long WFC, MS. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . 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A sign is posted in front of a Wells Fargo Bank on April 14, 2023 in San Bruno, California.

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