The Federal Reserve imposed new restrictions on the U.S. banking industry on Thursday after its annual stress test revealed that several banks could be uncomfortably close to minimum capital in coronavirus pandemic scenarios.
The Fed said in a press release that major banks will have to suspend share buybacks and limit dividend payments for the third quarter of this year to their current levels. The regulator also said dividends could only be paid based on a formula tied to a bank's recent earnings.
In addition, the industry is under constant scrutiny: for the first time in the ten-year history of the stress test, banks will have to resubmit their payout plans later this year, and payout restrictions may remain in place. They may have to repeat this cycle every quarter, the regulator said.
Bank stocks collapsed in New York after regular trading ended. Wells Fargo shares, which rose during the day, returned some of these gains, falling 3.3%. Goldman Sachs slumped 3.9%. JPMorgan Chase fell 1.9%.
"While I believe that banks will continue to manage their capital measures and liquidity risk prudently and to support the real economy, there is considerable uncertainty over the course of the economic recovery," said Randall Quarles, Fed chairman, in a statement. "As a result, the Board of Directors is taking steps to assess banks' conditions more closely and to require the largest banks to take prudent measures to conserve capital in the coming months."
The move signals that the unprecedented nature of the coronavirus pandemic and the difficulty in predicting the future of banks is making the Fed cautious. Regulators and industry are striving to avoid the mistakes of the previous crisis, in which companies made billions of dollars in cash to later raise capital. The largest US banks already announced in March that they would voluntarily suspend the share buyback, which accounts for around 70% of capital payments to the industry.
What remained were the dividends, most of which bank analysts assumed would stay at their current levels – with the exception of Wells Fargo, who has struggled to restore earnings after his fake account scandal. Still, option market traders bet that banks would be forced to cut dividends, even at JPMorgan, the largest and most profitable of the mega banks.
"These companies are effectively nationalized," said David Ellison, portfolio manager at Hennessy Funds, in a CNBC interview. "It sounds like buybacks are far from coming back, and dividends will depend on how the Fed views the economy."
Banks are expected to disclose their capital plans on Monday, June 29, and whether they will actually maintain their current dividend payouts.
Still, the industry seems to have avoided a bullet: Fed Governor Lael Brainard said in a separate statement that she advocated a blanket suspension of all payments to the industry. This would "create a level playing field and enable all banks to obtain capital without being at a competitive disadvantage compared to their competitors," she said.
In addition to the Fed's typical test, which examines how lenders are doing during a severe economic downturn, the regulator looked at three scenarios associated with the current pandemic: a V-shaped recession and recovery, a slower U-shaped outlook and a W-shaped scenario that would involve a double dip recession.
As the real economic consequences of the pandemic already exceed the typical severe economic downturn of previous audits, it is these three scenarios that are of greatest interest to bank analysts and investors.
While the Fed carefully pointed out that the scenarios are not predictions of what will actually happen, they are exactly what bank managers say, which could determine the course of the economy: unemployment would peak at up to 19.5%.
This could lead to credit losses of up to $ 700 billion for the 34 banks examined, and the industry's total capital ratio could drop from 12% in late 2019 to just 7.7%. The capital, which is the difference between a bank's assets and liabilities, serves as a cushion to absorb losses.
While most of the industry would remain well capitalized, in the tougher U-shaped and W-shaped scenarios, several banks would "approach minimum capital," the Fed said. However, the regulator did not disclose which banks would skate close to their minimum values.
The formula for dividend payments includes the average of net income over the past four quarters, Brainard said. This puts Wells Fargo at the greatest risk of dividend cuts, as its first quarter earnings were down nearly 90% as money was earmarked for credit losses.
In her statement, which was a rare dissenting opinion of the Fed's actions, she said that "it is inconsistent with the purpose of the stress test to allow banks to continue to make payments, even if they are limited," while preserving the Resilience, not backward through approval of payouts based on past quarters net income. "
Up to a quarter of the banks could be brought close to their minimum capital under the Covid 19 scenarios, said Brainard, who is the only remnant of the Fed's executive board from the Obama administration.
"Past experience shows that banks operating close to their minimum regulatory requirements are much less likely to meet the needs of creditworthy borrowers, and the resulting tightening of credit conditions could affect the recovery," she said. "Despite the significant likelihood that banks will need larger capital buffers to make up for losses in plausible scenarios, the approval allows distributions that exhaust the capital buffers."
With contributions from Jesse Pound of CNBC.