Thomas
Wade June 26, 2020
Executive
Summary
·
In the Federal Reserve’s (Fed) 2020 bank stress testing exercise,
all participating banks were deemed to have sufficient capital to weather a
crisis, even when judged against a separate, more extreme coronavirus sensitivity
analysis.
·
Despite this positive result, the Fed will prevent banks from
performing stock buybacks and capped dividends that could be paid in the third
quarter.
·
S. banks have been central to the coronavirus response and to
stabilizing the economy; it is undesirable to interfere with their business in
ways not supported by the results of the Fed’s own testing.
Introduction
It is not
an exaggeration to say that the economy is suffering near-unprecedented strain
in the wake of the disruption caused by the coronavirus pandemic. From wild swings in
the stock market, to an unemployment rate not seen since the Great Depression,
to forecasts that the U.S. economy will shrink 8 percent
this year, these circumstances clearly invite comparison to the
previous financial crisis of 2007–2008. Although some of the end results will
likely be and are already similar, the root causes could not be any more
different in that this economic crisis did not originate in the housing and
finance sectors. That is not to say that these industries are immune to the
impacts of the coronavirus, just that the crisis did not begin there and
circumstances have not revealed major systemic structural weaknesses.
At least
for now. Widescale distress in the economy necessarily adversely impacts the
safety and soundness of U.S. banks and housing finance actors. If either sector
were sufficiently imperiled, in the worst case scenario, the current economic
downturn could evolve the same distinguishing features of the previous crisis,
be they widespread defaults on mortgages or runs on banks, either of which
would severely worsen the recession and make the road to recovery that much
longer.
All of
which begs the question – how safe are banks? Fortunately, that answer has been
addressed in the most comprehensive way possible with the release of
this year’s stress testing results. The Federal Reserve (the Fed) has concluded
that all 33 banks involved in testing are well capitalized and “a source of
strength” to the economy. Despite this conclusion, the Fed announced
that in the third quarter banks could not perform stock buybacks and that
dividends repaid to shareholders would be capped. The Fed also announced, for
the first time in 10 years, that it would exercise its authority to require
banks to resubmit their 2020 capital plans, indicating the Fed’s concern about
the lack of certainty in the economic outlook.
The role
of stress testing
The
2007–2008 financial crisis, and the failure and subsequent bailout of some of
the world’s largest financial services firms, indicated a need for widescale
reform. The Comprehensive
Capital Analysis and Review (CCAR) is an annual exercise
performed by the Fed that seeks to determine whether banks (or, slightly more
specifically, bank holding companies with greater than $50 billion in assets,
operating in the United States) hold sufficient capital to appropriately manage
the unique risks each bank faces and be able to absorb losses in the event of
unforeseen crises. Note that the CCAR exercise is distinct from the Dodd-Frank
Act stress testing process (DFAST), which is a similar exercise with more of a
forward-focus, performed separately (although, in a break from tradition, the
Fed also released DFAST results on
the same day as CCAR).
Annual
stress testing is made up of two phases. The first phase, considered a lower
hurdle, measures whether banks are holding sufficient capital in the event of
hypothetical catastrophic losses. The second phase is considered more stringent
and focuses on a bank’s capital plan, including cash the bank intends to return
to shareholders. The results of stress tests are closely followed as the Fed
uses them, as seen above, to determine which firms it allows to issue dividends
and share buybacks.
The 2020
CCAR results
The 2020
CCAR process was unusual in two regards. First, for the first time in the history
of the CCAR individual firms did not pass or fail on the basis of their capital
adequacy. This is a result of a regulatory CCAR program change where the Fed
will from this year going forward use CCAR results to determine a bank’s
capital requirement for the following year. This is as opposed to allowing
banks to make this assessment themselves and providing oversight (a regulatory
change that eliminates autonomy from the banks, neuters the Fed’s most
effective oversight tool, and removes a vital layer of checks and balances).
Second,
the scenarios used by the Fed in the exercise were published in
February, before the impacts of the coronavirus had begun to be felt (the
worst-case scenario envisaged unemployment at 10 percent, significantly below
the current 13.3 percent).
Recognizing the need to address these unique challenges, the Fed also required
banks to undergo a supplementary “sensitivity” analysis that modelled the
impacts on bank capital of three different recovery scenarios: V-shaped (a
sharp decline and a sharp recovery); U-shaped (a sharp decline and a gradual
recovery); and W-shaped (a double recession). Unlike the normal CCAR, the Fed
did not release individual data for the sensitivity analysis, simply noting
that all firms in aggregate would meet minimum capital requirements (for a
primer on bank capital requirements, see here).
Bank capital would, however, decline from the 12 percent of Q4 2019 to
between 9.5 and 7.7
percent in the most adverse scenarios. Results of the
sensitivity analysis will not impact bank capital requirements in 2021.
At the
most fundamental level the 2020 CCAR results represent a win for the banking
industry, with Fed Vice Chair Randall Quarles noting that
banks have “served as a source of strength, not strain, in the current crisis”
and that “[t]he banking system remains well capitalized under even the harshest
of these downside scenarios—which are very harsh indeed.” This statement
appears to address fears that weaknesses in bank capital could have similar
implications as in the previous financial crisis, at least in the near term.
This
result was not an unqualified victory for the banks, however, as the Fed also
announced that for Q3 banks would not be able to perform stock buybacks, and
that the dividends banks could return to their shareholders would be capped. In
her dissenting statement, Federal Reserve Governor Brainard went further,
arguing that banks should be outright prevented from issuing dividends, not
merely capped. In addition, all banks involved in the exercise are also
required to resubmit their capital plans later this year. The actual impact of
these decisions will vary from bank to bank, rendering it difficult to say
precisely how dramatic this decision is. Certainly, eight of the largest banks
in the United States had already voluntarily
suspended buybacks for the first two quarters of the year. By
contrast, a restriction on dividends will hit many banks keenly, perhaps none
more so than Wells Fargo. The new rule requires that a bank’s dividend not
exceed average quarterly earnings for the previous year, something that
may outright prevent some
banks from issuing a dividend for the rest of the year.
The
broader context
These
results are best assessed with a view to the wider policy context, and in
particular the role of banks in emergency relief to businesses and recent moves
at the Fed to relax bank capital restrictions.
The most
significant legislative response to the coronavirus pandemic to date, the Coronavirus
Aid, Relief, and Economic Security (CARES) Act, set aside (an
initial) $349 billion to the Small Business Administration (SBA) to guarantee
loans to small businesses and $500 billion for the use of the Fed and Treasury
for emergency lending programs aimed at key businesses and larger firms. The
Fed has moved extremely
slowly on its portion of funds provided by CARES, but the SBA’s
Paycheck Protection Program (PPP) has by contrast been quite successful,
providing over $500 billion dollars to small firms across the country, an
enormous outlay of funds at rapid speed. The PPP has been the single most
effective aspect of the CARES legislative package, and singlehandedly
was the largest support for the economy for the month of April.
Getting over $500 billion to businesses in need in a matter of weeks is a
significant achievement of Congress, Treasury, and the SBA. Perhaps the most
credit, however, goes to the U.S. banking system, without which these loans
would not have been possible. Just four banks have to date provided over 10 percent of
all PPP loans by value, and the average size of PPP loans has decreased without
exception for weeks. Congress put U.S. banks front and center in the
government’s response to the coronavirus, and did so in a manner that at least
initially exposed banks to high degrees of risk, a significant portion of which
remains in the program today. There is no doubt that without the
involvement of U.S. banks, a far higher percentage of small businesses would
have gone under.
These
efforts are paralleled by continuous
efforts at the Fed to decrease the capital requirements placed
on banks, from allowing banks to use otherwise impermissible capital reserves
to adjusting supplementary leverage ratios. The Fed’s exertions have an obvious
motivation – to enhance the ability of banks to lend to those who need the
capital. The perhaps unintentional result of these efforts, however, has been
to almost incidentally roll back a number of Dodd-Frank provisions governing
bank safety. That banks were all deemed to be meeting minimum capital
requirements in not only the standard CCAR test but also in the most adverse
supplementary sensitivity test has the (presumably unintentional) result of
demonstrating that the reactionary restrictions of Dodd-Frank are not only
unnecessary but doubly unnecessary in times of economic health. That is an
aside, however; the key takeaway is that the Fed has used its powers to
encourage banks to shed capital to the fullest extent safely possible. Strange,
then, to penalize banks for not holding sufficient capital – which in and of
itself isn’t the case; banks are to be prohibited from their normal course of
business even though they meet all the requirements of the CCAR.
Conclusions
Fed Vice
Chair Quarles noted, “Today’s actions by the Board to preserve the high levels
of capital in the U.S. banking system are an acknowledgement of both the
strength of our largest banks as well as the high degree of uncertainty we
face.” This is a perfect encapsulation of the dual nature of the CCAR results.
Banks remain not only strong but an invaluable source of strength to the
economy. That the Fed is preventing banks from making buybacks and capping
dividends is a reflection of economic uncertainty, not a lack of safety at the
banks.
It
remains slightly troubling, however, that banks should be at the very center of
Congress’s legislative efforts to provide emergency relief to businesses and
yet have their ability to provide a return to their shareholders restricted.
Private banking is not an arm of government. If the Fed is concerned about the
safety of banks, penalizing them for having lower capital reserves while doing
everything possible to reduce capital buffers to encourage lending seems counterintuitive;
likewise, if Congress requires banks to keep the economy afloat, it makes
little sense to discourage private industry and investment. All that in
addition to showing scant gratitude to the providers of the single most
effective emergency lifeline to the economy.
https://www.americanactionforum.org/insight/u-s-banks-sufficiently-capitalized-even-against-worst-case-coronavirus-scenarios/#ixzz6QlHQJw2n
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