The Fed’s recent stress tests triggered sharp declines in US bank stocks amid concern over new capital buffer requirements. But bank fundamentals haven’t changed much, and earnings may be more resilient than expected in the face of a terrible economy.

Results as Expected—with a Twist

US banks are under the microscope as the COVID-19 recession challenges the financial sector. Investors watched closely when the Federal Reserve released the results of its annual bank stress test for the country’s largest banks after market close on June 25. Results were largely in line with expectations. But the next day, the already beleaguered KBW Bank Index fell 6.4% versus the market’s 2.4% loss—a stunning outcome for results that we do not believe will reduce bank earnings.

Stress test outcomes on three historic criteria did not trigger dramatic changes for the sector. Banks were told dividends may be maintained as long as there is earnings support but should not be raised; no stock buybacks for at least another quarter; and banks will have to resubmit capital plans later in the year.

Are Pandemic Solvency Concerns Overblown?

The new fourth test, a stress capital buffer because of the pandemic-induced recession, created a bit more angst. This ratio more closely aligns each bank’s capital requirements with its risk profile, and more importantly, it will become a day-to-day ongoing requirement from October 2020.

Some banks had already announced measures to reduce exposures in the stress capital buffer, such as balance sheet illiquidity. But the test results were still weak for some companies. The market reacted by pushing already low bank valuations to discounts that haven’t been seen since the global financial crisis (Display).