WASHINGTON — The Federal Reserve on Thursday temporarily restricted shareholder payouts by the nation’s biggest banks, barring them from buying back their own stocks or increasing dividend payments in the third quarter as regulators try to ensure banks remain strong enough to keep lending through the pandemic-induced downturn.
The decision to limit payouts is an admission by the Fed that large financial institutions, while far better off than they were in the financial crisis, remain vulnerable to an economic downturn unlike any other in modern history. With virus cases across the United States still surging and business activity subdued, it remains unclear when and how robustly the economy will recover.
Some of the Fed’s own loss projections for banks, in fact, suggest that the eventual hit to loans in a bad scenario could be far worse than in the aftermath of 2008.
Still, the Fed stopped short of barring banks from paying dividends next quarter, as some lawmakers and former regulators have urged — a decision that drew public criticism from one of the Fed’s current governors, who said not taking stronger measures could “impair the recovery.”
The Fed, which devised its primary stress test scenarios before the virus tore through the economy, will require the 34 biggest banks to resubmit and update their capital plans later this year, something it has usually required only for banks that failed to pass. Those plans detail how the banks intend to proceed with share buybacks and dividend increases in light of the pandemic, and the Fed said that resubmitting them “will help firms reassess their capital needs.”
It will also allow the Fed to reserve the right to run additional analyses, and potentially restrict payouts further, down the road.
“Today’s actions by the board to preserve the high levels of capital in the U.S. banking system are an acknowledgment of both the strength of our largest banks as well as the high degree of uncertainty we face,” Randal K. Quarles, the Fed’s vice chairman of supervision, said in a statement.
The central bank’s annual stress tests assess how the banks would fare under dire scenarios that include high unemployment and severe market turbulence. While those tests are meant to be hypothetical, this year’s scenarios were set before the pandemic, and some of the economic projections now look benign compared to reality. To compensate for that, the Fed ran an additional analysis to gauge how the banks would perform under coronavirus recessions of varying severity.
The hypothetical scenarios included a sharp bounce-back, an extended “U”-shaped downturn, and a double-dip “W” recession.
In aggregate, under those severe analyses, loan losses for the 34 banks ranged from $560 billion to $700 billion, and overall capital ratios declined from 12 percent in the fourth quarter of 2019 to between 9.5 percent and 7.7 percent.
The Fed did not release results for individual banks, as it does with the annual stress tests. But it did show that about a quarter of banks would nearly breach minimum capital ratios in a double-dip recession scenario, based on the report.
Given those results, the central bank will cap dividends to the amount paid in the second quarter, with an additional limitation based on recent earnings. While the eight largest banks had voluntarily suspended share buybacks through the second quarter, the Fed’s move will broaden and extend that limitation.
The Financial Services Forum, which represents the chief executives of the biggest U.S. banks, issued a muted statement saying that its members “appreciate the Federal Reserve’s work to promote financial stability during such extraordinary economic uncertainty and understand its decision regarding capital returns through the third quarter.”
Others felt that the Fed could have gone further to shore up the financial system. Officials could have placed formal restrictions on shareholder payouts earlier in the coronavirus crisis, and the decision to do so now is a sign that regulators believe the financial system could face threats if the downturn drags on. But the fact that the Fed’s demands are not stricter could limit the amount of buffer that banks have on hand to absorb losses and make loans to households and companies should borrowers struggle to repay debts over the coming months.
“A lot of this seems to be about preserving options,” said Daniel Tarullo, a former Fed governor and the original architect of much of the stress-testing regime who is now at Harvard. “That’s inconsistent with the idea of acting early in response to a major shock.”
Lael Brainard, a Fed governor who was nominated and confirmed during the Obama administration, objected to the fact that banks are still allowed to pay out dividends in any fashion.
“The payouts will amount to a depletion of loss-absorbing capital,” she wrote in a statement. “This is inconsistent with the purpose of the stress tests, which is to be forward-looking by preserving resilience, not backward-looking by authorizing payouts based on net income from past quarters that had already been paid out.”
Banks have been pushing the Fed to allow them to continue paying dividends, worried that restricting the regular payouts will hit their stock prices. But watchdog groups have been critical of the Fed’s leniency, pointing out that in the 2008 financial crisis, officials allowed money to walk out the door by failing to curb payouts, worsening the financial situation for struggling banks that ultimately failed.
For the largest banks, buybacks make up a bigger share of overall capital distributions while dividends are a smaller chunk. Of the $143 billion that the six biggest banks spent on capital distributions last year, $107 billion went to buybacks and $36 billion to dividends.
Even without across-the-board dividend restrictions, the performance on the normal stress tests could hamper some banks’ ability to continue payouts.
JPMorgan Chase, Citigroup, Bank of America and Wells Fargo, the four largest banks in the United States, all came through the stress tests with sufficient capital, according to a New York Times analysis of the Fed’s results. But capital at the fifth largest, Goldman Sachs, fell slightly below the required level, according to the analysis. The result could complicate any plans the Wall Street firm had for paying out capital to its shareholders if it doesn’t rise to the required amount by late this year as part of a new regulatory framework.
The Fed’s stress tests were introduced after the 2008 financial crisis as a way of making sure regulators had an up-to-date grasp of the risks in the banking system — something they lacked before the housing market crash. The exams focus on how much capital a bank would have left after the different stress scenarios.
Capital is money banks don’t have to pay back to creditors and depositors. The more capital they have, the more losses they can theoretically absorb.
Investors appear to have doubts about how the banks will perform in the recession.
Bank stocks are down by nearly a third this year, compared with a 5 percent decline for the S&P 500 stock index. Unlike in 2008, the banks aren’t the epicenter of the crisis and have actually experienced large inflows of money rather than outflows. Lending to corporations soared in the first quarter as companies drew on their credit lines and trading revenue surged at banks with large Wall Street operations. But their first-quarter earnings took a hit as they added billions of dollars to their loan loss reserves in anticipation of widespread defaults.
The Fed’s sensitivity analysis on Thursday suggested that banks could see a 10.3 percent four-quarter loan loss rate if the economy experiences a protracted downturn, and a 9.9 percent rate in the case of a double-dip recession. Those figures exceed the rates experienced by banks in the global financial crisis, when a smaller number of financial institutions experienced loss rates of 6.8 percent.
Back then, an early version of the stress test estimated that loss rates could total 9.1 percent over nine quarters.
That said, the sensitivity analyses were not full stress tests and did have some limitations. For instance, they did not incorporate the effects of government supports like the Paycheck Protection Program, which has funneled money to small businesses to keep them paying bills during widespread shutdowns.