Fed caps dividends after stress tests show big potential losses

The Federal Reserve is limiting the amount of dividends large US banks can distribute after stress tests showed lenders’ capital levels could fall sharply.

The impact of the coronavirus pandemic could see some large banks’ loan losses hitting levels much higher than the average reached during the financial crisis in 2008.

The stress tests revealed some banks’ capital levels could fall very close to the minimum requirements, making it “prudent” to restrict some capital distributions, the Fed said.

For the first time since the financial crisis, the Fed will also require banks to resubmit their capital plans later this year to take stock of any further developments in the economy. The move, which reflects the extreme uncertainty of the crisis, will enable the Fed to revisit capital distribution decisions when more information is available.

But one member of the Board of Governors, Lael Brainard, strongly criticised the dividend limit, arguing that banks should stop paying dividends entirely.

“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,” Brainard said. “This policy fails to learn a key lesson of the financial crisis, and I cannot support it.”

The restrictions apply only to third-quarter dividend payments. They  prevent banks from paying out amounts greater than their average quarterly profit for the four most recent quarters. It is not clear whether banks’ planned dividends would actually be affected by the cap.

Brainard said that allowing banks to make payments based on their 2019 profits is “problematic” at a time when future earnings are likely to decline. “This action creates a significant risk that banks will need to raise capital or curtail credit at a challenging time,” she said.

Capital impact

The Fed adopted a fresh approach for this year’s stress tests by adding three scenarios (see box: New approach). The new scenarios – which the Fed calls a “sensitivity analysis” – are based on hypothetical Covid-19 outcomes. They include a “V-shaped”, “U-shaped”, and “W-shaped” recovery.

The Fed only disclosed bank-specific results for the normal stress-testing scenarios. But the new scenarios show capital levels overall could fall significantly more than the most severe scenario in the normal regime.

The Common Equity Tier 1 capital ratios at the end of the fourth quarter of 2019 for the 33 banks assessed ranged from 9% to 26%. The average CET1 was 12%, and all banks were well above the 4.5% minimum requirement.

The bottom 25% of banks could see CET1 capital levels fall to as low as 5.5% under a U-shaped recovery and 4.8% under a W-shaped recovery. The most severe scenario in the normal regime showed capital levels could fall to 8% for the bottom 25% of banks.

Brainard argued that if banks’ capital ratios fell to these levels, they would still have negative impacts on the recovery despite being above the minimum.

“Past experience shows that banks operating close to their regulatory minimums are much less likely to meet the needs of creditworthy borrowers, and the resulting tightening of credit conditions could impair the recovery,” Brainard said.

In all three Covid-19 scenarios, the capital levels of the top 25% of banks do not fall below 10%.

On aggregate, the average capital levels for the V-shaped, U-shaped, and W-shaped recoveries could fall to 9.9%, 8.2% and 7.7%, respectively. The average capital levels under the most severe scenario in the normal regime could fall to 10.3%.

The Fed noted that its analysis “does not account for the capital depletion that would result from common equity distributions over the projection horizon”. It said that including “common equity distributions during the first half of 2020 would have resulted in a reduction in aggregate capital ratios of approximately 50 basis points.”

Brainard quoted this part of the Fed’s document to criticise its decision not to suspend equity payments. “Even without taking into account the authorised distributions, and only partially adjusting for the increased riskiness of the loans on bank balance sheets, the scenarios suggest that many banks could be operating within their stress capital buffers, and one quarter could be close to their minimum requirements,” she said.

Losses greater than global financial crisis

The largest contributor to the potential depletion of capital is losses from loans over the nine-month horizon, the Fed said. Banks could face loan losses significantly higher than in the financial crisis due to the build-up of non-financial corporate leverage in recent years, it warned.

Under a U-shaped recovery, banks could face loan losses of $700 billion on aggregate over the next nine months. That is an average loss rate of 10.2% of outstanding loans across the large US banks, compared with the 6.8% loan loss rate they suffered during the financial crisis.

The Fed warned that while the W-shaped recovery could see loan losses of $680 billion on aggregate over the nine-month horizon, loss rates would “remain particularly elevated” beyond the testing period. The average loan loss rate could be 9.9% over the nine-month horizon under this scenario.

Under the V-shaped recovery, the most optimistic of new scenarios, the loan loss rate could still be higher than the during the crisis at 8.1%. Losses for the entire banking sector could amount to $560 billion on aggregate in this scenario.