Jun 26, 2020 - Economy

Banks face the stress test of a lifetime

U.S. Federal Reserve building

Photo: Olivier Douliery/AFP/Getty Images

The Fed says several banks may not fare well if there's a U- or W-shaped economic recovery. That's why it says it’s cracking down on bank dividends and share buybacks — in a way never before seen since annual stress tests were implemented after the 2008 financial crisis.

The backstory: The Fed tested banks' balance sheets in new scenarios that might mirror what's ahead for the pandemic-hit economy. All 33 of the biggest banks passed the Fed's traditional test — but since the coronavirus crisis, the economic reality became worse than the hypothetical slump thought up by the Fed earlier this year.

Dividends: For the third quarter, the Fed said banks can't pay more dividends than it did in Q2. And the payout can't exceed what the bank has profited quarterly on average over the past four quarters.

  • The announcement to cap dividends was a surprise (unless you were closely watching the options market), but analysts estimate the new formula won’t force a dividend cut from any of the big six banks except for one: Wells Fargo.
  • Fed governor Lael Brainard said in a statement the Fed should have gone even further by temporarily barring dividends payouts altogether in Q3.

Stock buybacks: Banks can’t buy back shares next quarter. The industry's trade group already said in March banks would halt buybacks until Q2.

  • The banks were like other companies across industries in this regard as the pandemic began to roil the economy: quick to suspend stock repurchases, though they held onto dividend payouts.

Between the lines: In the worst-case scenario, the Fed says the banks in aggregate could see $700 billion in loan losses. Some would see capital drop to the minimum level that banks are required to hold.

The bottom line: "The banks, while proving themselves remarkably resilient because of their capital reserves, are still under enormous stress. Fundamentally banks are the fulcrum on which the macroeconomy functions," Karen Petrou, co-founder of Federal Financial Analytics, an advisory company, tells Axios.

  • What to watch: Banks begin to announce dividend plans for Q3 on Monday.
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