Top of the Morning: US Financials - Stress test results & earnings preview
The desk's analysis suggests that the recent stress test results conducted by the Federal Reserve indicate a robust health of US financial institutions, supporting our positive outlook on financial stocks. Per the full note from UBS, the annual stress tests evaluate banks under severe economic conditions, emphasizing resilience, which enhances credibility in lending practices. Notably, the projections of loan losses and capital levels being able to withstand downturns should bolster investor confidence ahead of the earnings season.
What the desk is arguing
The Federal Reserve's stress test outcomes portray large banks as well-capitalized and ready to absorb potential economic shocks. These tests, originally a response to the financial crisis, assess banks on their capacity to sustain capital through adverse scenarios, helping to ensure continuity in lending practices. Per the full note from UBS, the stress test findings are critical for maintaining the integrity of the financial system.
The most recent tests, conducted on June 24, 2026, underscored that US banks are projected to maintain capital levels above minimum requirements despite facing hypothetical severe economic downturns, which is crucial for preserving stability in lending and investment atmospheres. This demonstrates a significant shift in the operational soundness of banks compared to the tumultuous environment pre-2008, allowing for optimistic positioning as earnings reports near.
The alternative read would be that unexpected levels of loan losses or evolving macroeconomic conditions might challenge these forecasts, but the current data suggests an upward trajectory in capital adequacy ratios across major banks, reinforcing our stance.
01The Fed's stress test results imply that US banks are well-capitalized to absorb losses, enhancing confidence in financial sector stability.
02Projected capital levels for banks indicate they can withstand severe economic shocks, which is vital for continued lending capabilities.
03Upcoming earnings season is critical to assess the ongoing performance and resilience of US financial institutions.
04The overall optimism draws contrasts from earlier financial crises, highlighting improvements in bank capitalization since then.
Market implications
Traders should monitor financial sector stocks as they prepare for earnings releases, particularly given the positive backdrop of the stress test results. Look for key levels around 1.10 for USD movement as financial equities potentially respond to this data release.
Risks to this view
A significant increase in default rates or unexpected economic disruptions could undermine the positive assessments from the stress tests, leading to a downturn in bank stocks and altering investor sentiment sharply. Additionally, geopolitical factors or a surprise monetary policy shift could also disrupt forecasts.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we will spend some time updating you on U.S. financials through an equity and credit lens.
We will also spend some time reviewing the recent stress test results of the big banks from the Fed. This ties into a recent blog post from the UBS Chief Investment Office. A title is Federal Reserve Stress Test Results, Key Takeaways, and What Matters for Investors.
Authors of that blog, Jeff Harwood, financials equity strategist for the Americas, as well as Barry McElindan, senior fixed income strategist for the Americas, joining me here for today's episode. So before we get into it, Jeff and Barry, thank you both for dropping by and spending some time with our listeners for an update on the financials. Happy to be here.
Thanks for having us. Thank you, Dan. Let's begin going back, Jeff, to June 24th.
We did see that the Fed released the annual stress test results for the big banks and financial institutions. Maybe to begin for a bit of context for our listeners, Jeff, why does the Fed conduct these tests on an annual basis? Yeah, sure.
So this was one of the results of the great financial crisis, and so it started after that event. And the Federal Reserve's annual stress test is designed to assess whether large banks have sufficient capital to withstand a severe economic downturn. And banks are evaluated under a hypothetical severely adverse macro scenario that typically incorporates a sharp recession, rising unemployment, and declines in asset prices.
And then within this framework, the Fed projects loan losses, various revenue trends, and then the resulting path of capital levels for each of the banks. And the objective is just to ensure that banks are able to absorb losses while continuing to lend through a downturn, thereby supporting the financial system and stability overall. Now back in October, I recall Jeff, yourself, and Barry actually joined us at the time on top of the morning to talk about this, though the Fed actually overhauled the annual exam to improve transparency, so to speak.
So can you remind our listeners, Jeff, of what the changes at the time consisted of? Yeah, so there's a lot of changes kind of pending right now, and so nothing has quite been finalized yet. One of the key outputs of the stress test is the stress capital buffer for each bank, the SCB.
And that actually feeds directly into capital requirements for each bank, and it changes from year to year. And over the last few years, that number has actually been kind of volatile. So some of the changes that the Fed is looking to implement is just ways to reduce some of that volatility in the SCB, and that includes possibly just averaging the SCB over a two-year period, which would just smooth out the changes from year to year.
And then, importantly, the Fed is also increasing its transparency. So banks have argued that the test itself is kind of a black box from their perspective, and at times they're either disagreeing with some of the outputs or they simply don't understand how the Fed reached its conclusions. And so the Fed is increasing transparency.
It's disclosing more about the models that it's using, and part of this is somewhat related to a Supreme Court decision a couple of years back related to the Chevron doctrine. It's not directly related, but there is kind of some relationship there, it seems. But overall, the Fed is just looking to reduce the volatility of the SCB and increase transparency overall.
And I mentioned that a lot of this is still pending. It's all part of the comprehensive review of capital requirement reform that the Fed is – and other regulators are undertaking, and we hopefully get some clarity by year end. But this is all part of one big package.
HOFFMAN. So getting into the actual results, Jeff, how do they fare, the big banks, financial institutions? What are some key takeaways?
I mentioned yourself and Barry authored a blog on this, so it would be great, Jeff, to hear your thoughts. And, of course, we'll hear from Barry in a few moments as well to talk a bit about the credit implications. ZUCKERBERG.
Sure. So I mentioned that the SCB can sometimes be volatile from year to year. And while the Fed has these proposals kind of pending right now, they also decided to freeze SCBs at 2025 levels.
So importantly, with 2026 stress test results, there is no change to capital requirements this year. Now, that doesn't mean that the test is completely irrelevant. We can still see some helpful insights directionally on which way the SCBs may have been trending this year.
So there were a few net winners, not as many net losers. But interestingly, some of the regional banks only have to opt into this stress test every two years. And so with SCBs frozen this year, if there was a bank that opted into 2024 and then opted out of 2025, and if they have remixed their balance sheet to higher quality assets, that's not going to be reflected this year.
Their SCB and their capital requirements are still going to reflect the 2024 risk profiles. And so they're actually at a disadvantage with this SCB freeze. It's not a huge deal, but it is an interesting dynamic that there are some net losers just based on the frozen SCBs year over year.
HOFFMAN. And Barry, through a credit lens, what's important to highlight for our listeners and clients? What did you take away?
ZUCKERBERG. Just the weighting of banks within investment grade corporates. We estimate that there are about 13 percent of the investment grade corporate market, the banks that were stress tested.
And as Jeff mentioned, out of the 32 banks tested this year, we had some smaller Category 4 banks that get tested every other year, so there are 11 banks that fit that bill this year. So it really was a good sampling, a mix of both the global systemically important banks, the G-SIBs, super regionals, as well as some consumer finance Category 4 banks. And the main takeaways, I think, for credit investors is really supporting a positive fundamental credit profile that they exhibit, both from a credit rating agency standpoint as well as our CIO credit views.
As Jeff mentioned, these tests are designed to model a severe economic recession, and the banks that participated do show resilience to that as far as their balance sheet and capital levels go. As it relates to capital, the main metric is the common equity tier 1. That's an equity buffer, so that exists below bondholders, below preferred securities.
So even some takeaways for preferred investors is the added confidence in assuming structural subordination in a hybrid instrument because that equity capital buffer can still be there in an adverse scenario. Interestingly, to point out what the Fed stress test doesn't do is it does not model a rapid increase or spike in interest rates. The most common, I guess, problem period that we saw for regional banks in the U.S. in 2023 was caused by the rapid rise in interest rates.
That's actually not captured by the stress test because under a severe economic recession, it's actually assumed that interest rates fall. But nonetheless, it does give quite a bit of comfort on the ability for banks, like I said, to absorb this and reaffirm the stable credit profiles that we have for the sector. I think going forward, one thing that we'll be paying attention to is just how much buffers that banks retain above their minimum capital levels.
They are, as their balance sheet is being deployed in various business lines and also shareholder returns like dividends and buybacks, it's expected that this capital buffer will decline moderately but still remain ample above their minimum requirement. I guess, in theory, a decline in capital is not good from a bondholder perspective. But as long as the banks are doing it in a prudent fashion, it's not something that we expect will meaningfully cause their credit profiles to deteriorate.
But it is one thing coming out of this new holistic regulatory reform that will be important and also something that the credit rating agencies will look at, you know, banks' responses to this increased flexibility. Well, it is always fascinating to dig into these results and Jeff Barry, from hearing your remarks, clearly a lot of implications to both equity and credit investors to be mindful of. Before we move into our next topic, quickly again, want to highlight the blog so you, our listeners, can read further into these takeaways from Jeff and Barry.
This blog, by the way, is now available up on UBS.com slash CIO for your reference. The title, Federal Reserve Stress Test Results, Key Takeaways and What Matters for Investors. Get available up on UBS.com slash CIO.
So before we wrap up, since you're both here and we're coming up to yet another earning season, would be great to hear maybe some early expectations, what you're focusing on as we enter into the next reporting season. Jeff would be great to hear your thoughts and then we'll hear again from Barry from a credit perspective. Sure.
I think results for the group should be generally strong this quarter. Loan growth continues to come in better than anticipated. Capital markets activity has obviously been very strong with a lot of high profile deals.
Credit trends are remarkably stable year-to-date. I think the biggest question this quarter is going to be around the growth in deposits for each bank and the cost of those deposits. But overall, results look to be generally strong this quarter.
And Barry, what about your expectations through a credit lens? Yeah, we'll be focusing on the balance sheet during the last quarterly results. Banks provided more detailed information about their private credit exposure, so we'll see if they provide an update this next quarter, any updates there.
That'll be important. That's been a focal topic, as well as their overall common equity tier one capital ratios. Like I said, they did decline between fourth quarter 25 and first quarter 26.
We'll see if they allow for or are utilizing this flexibility to deploy the balance sheet further. We do see some incremental decline, but like I said, we expect it to still be within the realm of really strong credit profiles, especially for the large U.S. banks. Well, we'll definitely have to have a follow-up conversation once earnings season's behind us.
It would be great to dig into the results a bit further with you both, though a very timely conversation on the financials here today on top of the morning. Jeff Barry, thank you again for dropping by. Appreciate it.
Thanks for having us. Thank you very much, Jeff. Thank you for tuning in.
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