In the next few weeks the Federal Reserve will release the results of its annual set of stress tests designed to identify if the largest U.S. banks can survive a future financial crisis similar to one that shook up the global economy in 2008.
The tests use economic modeling to predict how each institution would fare during a hypothetical recession in which the unemployment rate peaks at 10% in the middle of 2017 and equity prices fall by about 50% through the end of 2016. The institutions' performance determines they extent to which they are allowed to buy back stock or pay dividends.
Analysts expect at least one or two of the biggest institutions -- dubbed "systemically important" by regulators -- will experience some trouble with the central bank's test, particularly when it comes to the central bank's qualitative evaluation of their risk management systems or capital planning procedures.
However, most of the 33 financial institutions undergoing the intense evaluations - especially the large regional banks -- are likely to be approved for modest increases in their buyback and dividend distributions.
Each bank undergoes two tests. The first one, known as the Dodd-Frank test, only considers existing capital distribution plans large financial institutions have set up over the past year while the second and more important set of tests -- known as the Comprehensive Capital Analysis and Review -- determines what shareholder buybacks and dividends they can make for the next 12 months.
Any poor performers on the Dodd-Frank test are unlikely to be permitted by the Fed through the CCAR tests released the following week to significantly increase their capital distribution plans in the coming months. The level of distributions permitted as a percentage of earnings can be interpreted by investors as an identification of the strength and health of each institution.
"A bank that is very thin or below their minimum ratios in the Dodd-Frank test could potentially be facing a failure in the CCAR test, or at least a situation where they might have to privately reduce their distribution proposal to receiving a passing grade," said Brian Klock, an analyst at Keefe, Bruyette & Woods Inc.
Nevertheless, analysts agree that a group of the regional mid-sized banks will generally be permitted to continue to distribute a large percentage of their earnings in buybacks and dividends over the next twelve months - even though there will be some outliers who will distribute above average while others for various reasons will distribute less.
A number of participating banks have continued to increase their internal capital -- as a result institutions expected to be on the high-end of distributions -- and the big winners of the tests -- include Fifth Third Bank (FITB) - Get ReportRegions Financial (RF) - Get Report , PNC Financial Services Group (PNC) - Get Report and State Street (STT) - Get Report , BBT (BBT) - Get Report and Ally Financial (ALLY) - Get Report are likely to experience the highest percentage point increase from the previous 12 months.
"The upcoming 12 months will be a capital return story for regional banks," said one analyst covering the tests. "They [regional banks] ramped up buybacks in 2015 and they are still at decent capital buffers and they will be on the higher side of the peer group when it comes to capital returns as a percentage of earnings in 2016 and 2017."
Nevertheless, a couple of tough assumptions banks must consider in the 2016 test's "severe adverse scenario" including negative interest rates and low oil prices will likely drive even the healthiest banks to request and receive only modest increases in their capital distribution plans.
On the other end of the spectrum, some "systemically important" banks, such as Comerica (CMA) - Get Report , are expected to ratchet down their capital distribution proposals this go-around due to their exposure to the energy sector through oil and gas loans. Klock said that the Dallas-based lender's move to lower distributions will likely be driven, partly, by trouble it will have with both the oil and gas and negative interest rate assumptions in the test. Comerica, Klock notes, isn't expected to fully execute on the distribution plan it initiated last year, which also suggests it will be more conservative this time.
A major question for analysts will be whether at least one of the big banks will be hit with some sort of qualitative-failure in 2016. The central bank last year raised serious concerns about Bank of America (BAC) - Get Report , telling the mega-institution to correct weaknesses in some elements of its capital planning process and it was required to resubmit its share buyback and dividend distribution plan in September.
Three mega-banks with large trading operations initially came below minimum capital buffer levels in last year's test - Goldman Sachs (GS) - Get Report , JPMorgan Chase (JPM) - Get Report and Morgan Stanley (MS) - Get Report -- but they all were able to pull themselves back above the bare minimums after resubmitting less ambitious capital distribution plans. "The Fed likes to ding one or more of the large banks to show they are in charge," said one analyst.
Klock agreed that the Fed could hit one of the biggest banks with qualitative issues around their controls, processes and data submissions. "The Fed could say they don't like the way they submitted their latest data points," he said.
Some U.S. and foreign banks with U.S. operations are conducting the tests for either the first or second time in 2016. However, these institutions, including TD Group (TD) - Get Report or Citizens Financial (CFG) - Get Report , aren't expected to experience any major trouble.
RBC Capital Markets predicts that Zions Bancorp (ZION) - Get Report will remain on the low end of distributions -- in the range of 12% of earnings down from 14% in the last period, taking into account only a continuation of its limited dividend. However, KBW's Klock said that the bank has worked out a lot of its problems and has a stronger balance sheet than before, a situation that could drive it to seek and receive approval for a stock buyback plan. "They've built up internal capital and fixed their balance sheet over the past few years," he said.
In addition, KeyCorp (KEY) - Get Report is expected to significantly cut back on its distribution request after the bank temporarily shut down its buyback program while it completes its $4.1 billion acquisition of First Niagara. First Niagara is reportedly facing scrutiny over its minority-lending practices by regulators but don't expect it to thwart the deal. One analyst said KeyCorp's move to increase their dividend in the second quarter of 2016 in the midst of its acquisition says a lot about the institution's strong level of capital.
RBC expects Fifth Third to distribute a significantly higher percentage of its earnings -- 101% of earnings for the 12 months starting in the third quarter of 2016 up from 83% during the last period. A key reason for the substantial hike is the bank's move in December to sell its large stake in Vantiv, their former subsidiary, for $419 million. "That netted them significant cash that they can use towards buybacks," said one analyst.
For now, expect most big regional banks to once again end up as the big winners in the Fed's stress tests.