The Federal Reserve announced Thursday that the largest US banks could easily withstand a severe recession, a milestone for the once-ailing industry.
The Fed announced when it released the results of its annual stress test that all 23 institutions in the 2021 test had remained “well above the minimum capital requirement” during a hypothetical economic downturn. Bank stocks popped after the release; the KBW Bank index rose by 1.5% at 5 p.m.
That scenario included a “severe global recession” that hits commercial property and corporate bondholders and culminates with 10.8% unemployment and a 55% decline in the stock market, the central bank said. While the industry would post $ 474 billion in losses, the loss-absorbing capital would still be more than double the minimum required, the Fed said.
If this year’s stress test had an anti-climatic note, it is because the industry saw a real-life version last year, when the coronavirus pandemic struck, leading to widespread economic disruption. Thanks to the help of the legislature and the Fed itself, the banks did extremely well during the crisis and increased capital for expected loan defaults, which mostly did not occur.
Still, banks had to undergo additional stress tests during the pandemic and limit their ability to return capital to shareholders in the form of dividends and buybacks. These are now being lifted, as the Fed has already announced.
“Last year the Federal Reserve conducted three stress tests of several different hypothetical recessions and all of them confirmed that the banking system is well positioned to support the ongoing recovery,” Randal K. Quarles, vice chairman of the supervisory authority, said in a statement.
Dividend increases and buybacks are coming
After passing this latest test, the industry will regain a level of autonomy it has lost since the last crisis. After playing a key role in the 2008 financial crisis, banks had to undergo industry scrutiny and ask regulators for permission to raise dividends and buy back stocks.
As part of the so-called stress capital buffer framework, banks will now gain flexibility in the distribution of dividends and buybacks. The stress capital buffer is a measure of the capital that every company must hold based on the risk of its business operations. The new regime was supposed to start last year, but the pandemic kicked in.
“As long as they stay above this requirement for the stress capital buffer and all of their other requirements each quarter, a bank can technically do whatever it wants in terms of buybacks and dividends,” Jefferies bank analyst Ken Usdin told CNBC this week.
During a background conversation with reporters, senior Fed officials opposed the idea that the new regime would lead to a free-for-all regime. Banks are still constrained and the Fed is confident that the stress capital buffer framework will protect their ability to support the economy during a downturn, they said.
While analysts have said they expect the industry to hike buybacks and dividends by tens of billions of dollars as of July, the Fed has ordered lenders to wait until Monday afternoon to reveal their plans, according to people with knowledge of the situation. Then a flood of press releases is expected.
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