Fed Warns Banks to Shore Up Capital for Pandemic Survival

The Federal Reserve announced several restrictions for banks going forward, as stress tests show they are adequately capitalized to handle a rocky economic recovery.

Charts from a Thursday report by the Federal Reserve project real GDP growth rate (left) and the National House Price Index (right) in a severely adverse scenario.

MANHATTAN (CN) — The largest banks should be able to weather any economic storm later this year but must tighten their belts, according to stress tests released after Thursday’s closing bell. 

“The banking system has been a source of strength during this crisis, and the results of our sensitivity analyses show that our banks can remain strong in the face of even the harshest shocks,” Federal Reserve Vice Chair Randal Quarles said in a statement after the central bank released its annual stress tests.

Investors were not rollicked by the news, nor were they encouraged. Stock futures remained slightly negative, and at the morning bell the Dow Jones Industrial Average lost just under 200 points. The S&P 500 and Nasdaq saw milder declines. 

The Fed’s stress tests, which were started after the Great Recession to examine the strength of financial institutions’ balance sheets under a variety of situations, were adapted this year to include the coronavirus pandemic. What they did not take into account, however, were government stimulus payments and expanded unemployment insurance.

The central bank tested banks against high unemployment of 15.6% to 19.5% under three scenarios: a quick, V-shaped recovery; a slower U-shaped recovery; and a rocky W-shaped rebound. 

The 34 banks suffered aggregate loan losses of $560 billion to $700 billion in the hypothetical economic recoveries, and aggregate capital ratios fell from 12% in the fourth quarter of 2019 to 9.5% and 7.7%. 

As a result of the stress tests, the Fed is taking several measures to guarantee banks are ready for a worst-case scenario.

Share buybacks are out during the third quarter, for one. Share repurchases represented about 70% of shareholder payouts from big banks in recent years, the Fed stated. 

Stock buybacks are widely used among public companies but have become controversial. They are seen by some as a way to artificially inflate stock prices since there are fewer publicly available shares, they provide a windfall to executives whose compensation is tied to the share price, and they can drain corporate treasuries.

Dividends will be curbed, as well, with banks unable to pay out more to investors than they paid during the second quarter and tying them to recent earnings.

Further, for the first time in a decade, banks must re-evaluate their longer-term capital plans and resubmit their payout plans to the Fed later this year for another mini-stress test. The Fed will conduct quarterly analyses to see if banks need to make adjustments to their reserves.

Quarles noted that if the economic landscape becomes rockier, the Fed may take additional steps. “If the circumstances warrant, we will not hesitate to take additional policy actions to support the U.S. economy and banking system,” he said.

Analysts also expect the Fed may do more. In a Friday investor note, researchers at Goldman Sachs, who forecast a U-shaped recovery, wrote that “there is a high probability that capital requirements could increase over the course of a year.”

Federal Reserve Governor Lael Brainard, an Obama appointee, wanted to go even further by limiting all banks’ payouts.

“The payouts will amount to a depletion of loss absorbing capital,” she wrote in a separate statement. “Using backward-looking earnings as the basis for payouts in a forward-looking capital framework is problematic at a time when future earnings are likely to decline and required buffers are likely to rise.”

Individual banks may release their own results on June 29, during which they will also determine their dividend payouts.

Banks also received more good news on Thursday, as banking regulators eased regulations allowing them to widen their ability to invest in hedge funds and with government-insured deposits. The so-called Volcker rule was drafted after the 2008-09 recession to prevent banks from the kinds of excessive investment that caused the credit crisis.

Brainard is among those who have criticized the move. “It is a mistake to weaken banks’ strong capital buffers when they are clearing proving their value in the first serious test since the global financial crisis,” he said.

Others see the benefit of removing banks from their financial silos but are still nervous about a return to pre-2008 banking excesses. 

“The banking system is under pressure at the moment so there is an argument to be made that assisting the banks will allow them to operate more freely,” David Madden of CMC Markets wrote in a note. “On the other hand, if the system is feeling the strain of the pandemic, is now the best time to be cutting back on regulation?”

On Wall Street, investors this week have sloughed off recent gains as a bevy of bad news has rolled in, including stubbornly high unemployment claims, a U.S. economy that officially contracted 5% in the first quarter of 2020, and a trade deficit that grew by 5% in May after exports fell sharply. 

Wall Street also has remained fixated on the recent uptick in coronavirus cases and hospitalizations the last few days. The United States has hit record new cases several days this week, most recently on Thursday when nearly 40,000 people contracted the virus.

To date, more than 9.6 million people have been infected by Covid-19 worldwide, while nearly 490,000 have died, according to data compiled by Johns Hopkins University. In the United States, 2.4 million people have contracted Covid-19, while more than 124,000 have died.

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