The Federal Reserve relaxed its restrictions on capital distributions by big banks after a special round of stress tests found that they have the capital to weather a sharp downturn in economic conditions.
The Fed tested the banks against what would amount to an abrupt unraveling of the recovery that now appears to be underway, using two scenarios with severe double-dip recessions that would produce heavy loan losses but leave the banks with required capital cushions largely intact.
The central bank said the banks would rack up more than $600 billion in total losses under both simulations, but that their aggregate common equity Tier 1 ratio would hit bottom at 9.6% over a nine-quarter period ending in the third quarter of 2022.
"Today's stress test results confirm that large banks could continue to lend to households and businesses even during a sharply adverse future turn in the economy," Randal Quarles, the Fed's vice chairman for supervision, said in a news release. The Fed noted that big banks have increased capital levels despite setting aside large amounts of money to absorb loan losses.
Because of ongoing economic uncertainties, the Fed said it would continue to limit dividends and share buybacks based on recent income in the first quarter of 2021. The Fed had prohibited buybacks altogether in the second half of 2020. "If a firm does not earn income, it will not be able to pay a dividend or make repurchases," the Fed said. In the first quarter of 2021, the amount of dividends and repurchases combined cannot exceed average quarterly net income over the preceding four quarters.
A number of analysts had expected the Fed to continue with the previous payout limits without modification, but said they expected markets to take the extension of the restrictions in stride, arguing that a return to share repurchases would just be a matter of time if regulators again concluded that banks generally have healthy levels of capital.
Fed Governor Lael Brainard, an Obama administration appointee, dissented against the capital distribution limits, arguing for stricter policy.
"For several large banks, projected losses take capital levels very close to the minimum requirement, in the range where banks tend to pull back from lending, even before payouts," she said in a statement. "Today's action nearly doubles the amount of capital permitted to be paid out relative to last quarter. Prudence would call for more modest payouts to preserve lending to households and borrowers during an exceptionally challenging winter."
Almost all the stress test banks already held capital in excess — some well in excess — of new buffer requirements determined by estimated losses under the severely adverse scenario in the regular annual stress tests held in June. In previous years, regulators could reject banks' capital plans if similar scenarios suggested that dangerous depletions in capital levels were possible, meaning that banks were effectively subject to capital limits comparable to those formalized by the introduction of stress capital buffers in October. The Fed said it would not reset capital requirements after the December stress tests.
The June assessment also included updated scenarios designed to map out plausible impacts from the pandemic that were more onerous than the severely adverse scenario, which had been formulated in February. The Fed did not publish these results for individual banks. But under a W-shaped, double-dip recession scenario, the simulation found that losses would push a quarter of the 33 stress test banks to a CET1 ratio of 4.8% or less. The minimum is 4.5%. In her statement in June, Brainard said "the scenarios suggest that many banks could be operating within their stress capital buffers, and one quarter could be close to their minimum requirements."
The scenarios used in the new stress tests were not generally as severe as the ones in June's special pandemic assessment — under which unemployment hit peaks of 15.6% to 19.5% — but would reflect a harsh deterioration from current conditions. The new scenarios were tied to conditions and forecasts that prevailed in the third quarter, and the Fed said its procedures call for lower hypothetical increases in unemployment when jobless rates are already high.
Under the new severely adverse scenario, unemployment would jump back up to 12.5% at the end of 2021. Under the alternative severe scenario, unemployment would peak at 11%, but take longer to recover. The actual unemployment rate was 6.7% in November.
The Fed said it made several model adjustments in the December stress tests to align the simulations more closely to unique risks and circumstances that have arisen in 2020, including lowering collateral recovery rates on hotels in markets with high vacancies.
Under the severely adverse scenario, M&T Bank Corp.'s domestic commercial real estate losses were $6 billion in the December stress tests, up from $2.2 billion in the June stress tests. Its CET1 ratio bottomed out at 5% under this scenario in the December stress tests, compared with 8.5% in June.
Analysts had widely anticipated that restrictions on capital distributions by large banks would be extended into the first quarter, and possibly extended further into 2021 later on, because of economic uncertainty created by the pandemic.
Many large banks voluntarily suspended share repurchases at the onset of the pandemic, before the Fed banned them directly in June. But for several months, a number of the biggest banks have said they would probably have enough capital to resume buybacks at the beginning of 2021. Bank of America Corp. has "a lot of excess capital," Chairman, President and CEO Brian Moynihan said at a conference in December, and the company will restart repurchases "as soon as we're allowed."
Both Wells Fargo & Co. and Capital One Financial Corp. cut their dividends after the Fed initially announced the restrictions. Wells Fargo also has "excess capital," CEO Charles Scharf said at an appearance in December, but the bank is unlikely to buy back stock early in 2021. It needs a "clear line of sight" into a sustainable and broad improvement in the economy, he said.
The Fed's previous restrictions limited dividend payouts to no more than the quarterly average of a bank's net income over the preceding four quarters. Using earnings estimates, Compass Point analyst David Rochester calculated in a note on Dec. 18 that no bank among a large group of institutions with more than $100 billion of assets would have to further reduce its dividend because of the formula.