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Fed bans stock buybacks, caps dividend payments for big banks after stress tests

The Federal Reserve on Thursday banned more than 30 large U.S. banks from buying back their stocks and limited the size of dividends they could pay out to shareholders due to the financial strain of the coronavirus recession.

The Fed’s announcement came as the central bank released the results of 2020 stress tests mandated under the Dodd-Frank Wall Street reform law passed in the wake of the 2007-09 financial crisis. 

The Fed tested banks on their ability to weather two hypothetical scenarios — a baseline of typical economic conditions and a “severely adverse scenario” — and three coronavirus-specific situations: a V-shaped recession and recovery; a slower, U-shaped recession and recovery; and a W-shaped, double-dip recession.

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While the 33 banks subject to the 2020 Fed stress tests met the standards to prove they would be able to retain enough capital to stay solvent through a deeper crisis, the Fed said several banks came close to the minimum levels of cash reserves mandated by Dodd-Frank.

For that reason, the Fed is ordering banks to suspend any planned stock buybacks during the third quarter of 2020 and capping the size of dividends for at least that time.

“Today's actions by the Board to preserve the high levels of capital in the U.S. banking system are an acknowledgement of both the strength of our largest banks as well as the high degree of uncertainty we face," said Fed Vice Chairman for Supervision Randal Quarles.

“If the circumstances warrant, we will not hesitate to take additional policy actions to support the U.S. economy and banking system. I support today's actions to ensure banks remain an ongoing source of strength to the U.S. economy,” he added.

The unprecedented speed and scale of the pandemic-driven recession is the first major test of the stricter bank regulations imposed after the 2007-08 financial crisis. Unlike in 2008, banks have largely remained resilient in the face of the broad shutdown of the U.S. economy thanks in part to record-shattering fiscal and monetary stimulus.

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The Fed also faced challenges in adequately testing banks on their abilities to withstand the uncertain path of the coronavirus downturn. The current unemployment rate of 13.3 percent is actually 3.3 percentage points above the level of joblessness included in the Fed’s severely adverse scenario.

“By mid-March, it became clear that the COVID event was disrupting U.S. economic activity and that even more extreme downside outcomes than the 2020 severely adverse scenario were plausible, especially for near-term unemployment and gross domestic product (GDP),” the Fed said Thursday.

The specific tests gauged banks on how they would be able to handle the unemployment rate spiking to as high as 19.5 percent and GDP falling at an annualized rate of 31.5 percent in the second quarter of 2020. 

The 14.7-percent April unemployment would have likely been 5 percentage points higher if not for a classification error, according to the Bureau of Labor Statistics, and second quarter GDP is projected to have fallen close to the Fed’s worst coronavirus-related scenario.

The Fed said the coronavirus-related analyses were not to be taken as official projections, but rather a range of potential outcomes meant to help banks prepare for a deeper downturn.

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“As a result, the Board is taking action to assess banks' conditions more intensively and to require the largest banks to adopt prudent measures to preserve capital in the coming months,” Quarles said.

But Fed Governor Lael Brainard, the only Democrat on the central bank’s board of governors, objected to the decision to allow banks to distribute any dividends, citing the uncertainty facing the economy.

“It is a mistake to weaken banks' strong capital buffers when they are clearly proving their value in the first serious test since the global financial crisis. This is a time for large banks to preserve capital, so they can be a source of strength in a robust recovery,” Brainard said in a statement.

“I do not support giving the green light for large banks to deplete capital, which raises the risk they will need to tighten credit or rebuild capital during the recovery," she added. "This policy fails to learn a key lesson of the financial crisis, and I cannot support it.”