Stress tests: Can U.S. banks weather coronavirus crisis?

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JPMorgan CEO Jamie Dimon, last week, said that he sees a “bad recession” coming in 2020. However, the CEO also assured that the largest U.S. bank would stay strong even in the worst-case scenario. Credit Suisse applied a similar worst-case scenario to other large U.S. banks to know whether or not their capital adequacy is enough to survive the coronavirus induced financial crisis.

Using worst-case scenario to assess capital adequacy

In an annual letter published Monday, Dimon noted that they are preparing for “an extremely adverse scenario.” This scenario is worse than the 2008 financial crisis and recession.

Dimon’s worst-case scenario “assumes an even deeper contraction,” including GDP (gross domestic product) dropping 35% in the second quarter and remaining down throughout the year, and unemployment peaking at 14% at the end of the year.

Dimon referred to this scenario as “quite severe and, we hope, unlikely.” In case this scenario turns out to be real, Dimon said the board may have to suspend the dividend. Such a decision, as per the CEO, would “be out of extreme prudence and based upon continued uncertainty over what the next few years will bring.”

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According to Dimon, if such a scenario becomes real, the company would still end the year with strong liquidity and a CET1 ratio of approximately 9.5%.

Credit Suisse analysts used JPMorgan’s worst-case scenario idea to stress test other major banks in the U.S. to determine if their capital adequacy is enough to weather the coronavirus crisis.

U.S. banks prepared for coronavirus crisis?

As per the analysts, if all the banks perform well in an adverse scenario and use only their capital conservation buffers, it would instill confidence among the investors.

“If all of our banks could fare as well as JPMorgan in an extremely adverse scenario—dipping into their capital conservation buffers, but nothing more—it would validate the regulatory framework and build confidence in recommending/ investing in the group,” Credit Suisse analysts wrote in a report dated April 13.

As per the analysts, their analysis “supports the thesis that adequate capital/CET 1 is in place for the large cap banks.”

Further, the analysts noted that they would continue to adjust their analysis as more data points become available. The report studied the following “Outperform rated” banks in their coverage – JPMorgan, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley and Bank of New York Mellon.

The adverse scenario that Credit Suisse analysts used for the stress testing included “incremental revenue pressure (net interest margin compression, reduced banking fees, weaker market-related and trading revenues), even higher net loss rates on a larger base of loans (factoring in a prolonged period of drawdowns/increased bank financing demand) and material RWA inflation.”

As per the analysts, these assumptions had a material impact on the earnings of the banks. In some cases, it even resulted in a net loss. The analysts calculated the end point CET 1 at more than 300bps above the minimum requirement. As per the analysts, none of the banks dropped to “more than 120bps into the 2.5% capital conservation buffer.”

For the analysis, the required capital as defined by the analysts includes “CET 1: 4.5% base + GSIB surcharge; 2.5% capital conservation buffer available.”

Banks earnings: what to look for

Separately, many big U.S. banks will report their first quarter earnings this week. Though the banks have already given hints on how the coronavirus would impact their earnings, there is still a lot to be known. There would be several numbers to watch for in the earnings reports. These numbers would give a fair idea on how prepared these banks are to weather the slump due to the coronavirus.

One item to watch would be the provisions. This number would tell how much extra the banks have set aside for the loans. Despite uncertainty over the loan losses, it is very much expected that banks would raise their reserve level. Moreover, these provisions would suggest what banks think about this coronavirus crisis.

Another item that analysts will be interested in is the bank’s loan book. Due to the coronavirus crisis, there has been a significant jump in lending. As per the data from Morgan Stanley, the U.S. listed companies have drawn over $223 billion of credit lines this year, with almost two-third occurring between March 17 and March 19.

With almost zero economic activity, companies and individuals are turning to debt to meet their expenses. The government would meet some of this demand through its $350 billion small business grants program and $454 billion scheme for larger companies. Still, analysts would want to know the size of the banks’ loan book and capacity to grow further.

Many eyes will also be on any announcement from the banks regarding interest holidays, fee waivers and programs for the relief workers. Regulators are encouraging banks to go for forbearance, arguing that it would benefit in the long term and that is always better than people defaulting.