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Bank stress tests don't account for pandemic but may still have benefits

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Bank stress tests don't account for pandemic but may still have benefits

The Federal Reserve's upcoming stress tests of the largest U.S. banks will have one crucial limitation: they will not examine how banks would withstand a pandemic-induced recession.

But there may still be some benefits to moving forward with the annual stress tests, analysts say, such as providing more transparency into the state of bank balance sheets and potentially offering another chance to signal that banks are much healthier today than in 2008.

The annual exams test the ability of banks to withstand a hypothetical "severely adverse" scenario the Fed designs, with consequences attached to falling short on key metrics. The conjured scenario for this year is dire: a U.S. recession in which the unemployment rate peaks at 10%, stock prices drop by 50% and commercial real estate prices fall 35%, among other things.

Still, those numbers are starting to look rosy compared to the actual situation U.S. banks are likely to face this year, so it is "safe to assume that most banks would be happy" if the economic damage is limited to the scenario the Fed designed, said Laura Brown, a managing director at Protiviti who advises banks on risk and compliance issues.

"They expect it's going to be certainly worse than that," Brown said.

Some economists believe the U.S. unemployment rate has already surpassed the 10% mark, pointing to the record number of Americans who are filing for unemployment benefits as a sign of the damage the labor market is suffering. Some market indicators also showed more stress in March than under the Fed's severely adverse scenario, most notably the "fear index" — a measure of market volatility that spiked dramatically in the middle of the month.

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The worsening economic projections have led observes to ask whether the Fed's stress tests will provide any valuable information on banks' health.

Former Fed Governor Daniel Tarullo, the architect of many of the Fed's post-crisis regulations, told CNBC on April 2 he would lean toward delaying the stress tests because they will not match "even closely" the coming actual stresses on banks. Tarullo said there were good arguments on both sides of the issue, though he would prefer that banks and the Fed "focus like a laser beam" on the current strains in the system and go through more normal tests once the markets have stabilized.

The Bank of England canceled its bank stress tests this year, saying it prefers institutions to spend their time helping customers get through the coronavirus crisis.

The Fed has thus far pressed on with the annual process, asking banks to submit reams of balance sheet information this week along with their capital distribution plans for the coming quarters. It also finalized a significant overhaul of the process by introducing a new measure called the stress capital buffer. If the process moves forward as usual, the Fed will announce the results of the stress tests this summer.

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The debate is a reminder that stress tests are helpful but are an "imperfect tool" to give the public a full assurance of the banking industry's health, said Kathryn Judge, a law professor at Columbia University who focuses on financial regulation.

"We're never going to get the scenario perfect relative to what reality is going to look like," Judge said. "More importantly, once reality gets messy, there's going to be feedback loops that cause banks to suffer in ways that the stress tests probably will not accurately predict."

The Fed's stress tests were borne out of the 2007-09 financial crisis, with officials seeing the first exams in 2009 as a way to re-instill confidence in the banking system as fears dominated the market. The strategy worked, with the results showing some banks continuing to fall short on capital but broadly suggesting the health of their balance sheets had improved drastically.

Regulators may apply a similar logic this time around, worrying that a suspension of the stress tests could "unwittingly suggest that the Fed is more concerned" about the banking system than it actually is, said Allison Breault, a bank lawyer at the firm Cleary Gottlieb.

Dividends

Some clues on the issue may come on April 10, when Fed Vice Chairman for Supervision Randal Quarles is scheduled to speak via a University of Utah webcast on the banking system.

Fed officials have also faced a related question of whether they should suspend large banks' dividend payments to their shareholders, but Fed Chairman Jerome Powell said on an April 9 Brookings Institution webcast that pausing dividends is "not something that needs to be done at this point."

"We'll be watching to see how things evolve, but I don't think that step is appropriate at this time," Powell said, noting that banks have far more capital today than in 2008, and their capital bases are of higher quality.

Those who have backed suspending the dividends include former Fed Chair Janet Yellen, who told CNBC this month that the action would help ensure banks have enough capital available to "meet the credit needs of the economy" if the downturn proves to be long-lasting.

READ MORE: Sign up for our weekly coronavirus newsletter here, and read our latest coverage on the crisis here.

Several Fed officials advocated for discouraging banks to make dividend payments at the Federal Open Market Committee's March 15 meeting, according to minutes of the emergency gathering. But the minutes did not offer information on which officials backed that approach, a detail that is critical since the D.C.-based Board of Governors is in charge of that decision rather than the full FOMC, which includes the Fed's 12 regional bank presidents.

The CEOs of the biggest U.S. banks have expressed reluctance at halting the dividend payments, with Citigroup Inc. CEO Michael Corbat telling CNBC recently that "our dividend is sound, and we plan on continuing to pay it."

The major banks have, however, all paused all share repurchases until the second half of the year. That is a significant development given that those make up about 70% of banks' capital distributions, Powell said during the Brookings Institution event.

In one comment that drew attention, JPMorgan Chase & Co. CEO Jamie Dimon wrote in his annual letter to shareholders the bank would consider suspending dividends under an "extremely adverse scenario" in which GDP contracts by 35% in the second quarter and lasts through the end of the year and unemployment hits a high of 14% in the fourth quarter. JPMorgan is the country's largest bank by assets.

Judge, the Columbia University professor, said banks are "rationally hesitant" to suspend payouts individually, so regulators should "step up" and force banks to make decisions that will enhance the banking system's capacity to withstand losses.

The annual stress testing and capital planning process is the usual avenue through which the Fed puts limitations on banks' capital distributions. But the Fed is able to limit dividends outside of that process and should do so as soon as possible, partly because the stress tests are based on banks' balance sheets as of Dec. 31, 2019 and do not reflect the current strains, said Jeremy Kress, a former Fed lawyer who now teaches at the University of Michigan.

"Even if all the banks pass the stress tests, that says nothing about whether they are healthy enough to pay out dividends today," Kress said.