Fed Stress Tests Order Banks to Preserve Capital By Suspending Buybacks and Limit Dividends

The Federal Reserve completed its annual stress test on Thursday for 2020 and additional sensitivity analyses that the Board conducted in light of the coronavirus event. The Fed capped bank dividend payments and suspended share-buybacks for the third quarter.

The Federal Reserve completed its annual stress test on Thursday for 2020 and additional sensitivity analyses that the Board conducted in light of the coronavirus event. The Fed capped bank dividend payments and suspended share-buybacks for the third quarter.

Fed Stress Tet 2020 

The announcement came after the conclusion of the annual stress-test exercise known as the Comprehensive Capital Analysis and Review of the 34 firms that hold about 80% of the total assets in the U.S. financial system. This includes 5 foreign firms.

The Fed released two studies—a traditional stress test set in February before the pandemic and an analysis of bank capital under three ways the economy might

The traditional stress test showed that all large banks remain well capitalized. evolve in coming quarters amid the public-health crisis, roughly a V-shaped, U-shaped and W-shaped scenarios. 

“The banking system has been a source of strength during this crisis,” Vice Chair Randal K. Quarles said, “and the results of our sensitivity analyses show that our banks can remain strong in the face of even the harshest shocks.”

In addition to its normal stress test, the Board conducted a sensitivity analysis to assess the resiliency of large banks under three hypothetical recessions, or downside scenarios, which could result from the coronavirus event. The scenarios included a V-shaped recession and recovery; a slower, U-shaped recession and recovery; and a W-shaped, double-dip recession.

In the three downside scenarios, the unemployment rate peaked at between 15.6 percent and 19.5 percent, which is significantly more stringent than any of the Board’s pre-coronavirus stress test scenarios. The scenarios are not predictions or forecasts of the likely path of the economy or financial markets.

Banks to Preserve Capital by suspending Buybacks and Limit Dividends.

The Federal Reserve voted to require large banks to preserve capital by suspending share repurchases and cap dividend payments in the third quarter in a 4-to-1 vote. Fed Gov. Lael Brainard dissented from the decisions saying “I do not support giving the green light for large banks to deplete capital,” she said, arguing instead for a blanket suspension of dividends..

The Fed will tie the distribution of dividends to a formula based on recent income. The formula sets third-quarter dividends at a level equal to average net income over the past four quarters. By that calculation, some banks may have to cut their dividends.

A senior Fed official said this could be “binding” for some banks. A senior Fed official said the Fed will go forward on a quarter-by-quarter basis. And banks net income might be reduced given the impact of the pandemic.

Under the very worst of the COVID-19 scenarios, “many” banks would be operating within their stress capital buffers and one quarter of the banks would be getting close to minimum capital standards, Brainard said.

“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,” she added.

The Fed said it would require banks to reassess their capital needs and resubmit capital plans later this year.

Supervisory Scenarios 

On February 6, 2020, the Federal Reserve releasedthe two supervisory scenarios: baseline and severelyadverse.10 This section describes the severely adverse scenario that was used for the DFAST 2020 projec-tions contained in this report. These scenarios weredeveloped using the approach described in the Board’s Policy Statement on the Scenario Design Framework for Stress Testing.

The severely adverse scenario is not a forecast but rather a hypotheticalscenario designed to assess the strength of bankingorganizations and their resilience to an unfavorableeconomic environment.

The DFAST 2020 supervisory scenarios include tra-jectories for 28 variables. These include 16 variablesthat capture economic activity, asset prices, andinterest rates in the U.S. economy and financial mar-kets, and 12 variables made up of 3 variables (realgross domestic product (GDP) growth, inflation, andthe U.S./foreign currency exchange rate) for each of4 countries/country blocks.

Similar to DFAST 2019, the Federal Reserve applieda global market shock to the trading portfolio of11 firms with large trading and private equity expo-sures and a counterparty default scenario compo-nent to 13 firms with substantial trading, processing,or custodial operations (see “Global Market Shockand Counterparty Default Components”).

The severely adverse scenario is characterized by asevere global recession accompanied by a period of heightened stress in commercial real estate and corporate debt markets

.The U.S. unemployment rate climbs to a peak of10 percent in the third quarter of 2021 (seeTable A.5). This substantial increase in the unemployment rate is consistent with the Board’s PolicyStatement on the Scenario Design Framework fo rStress Testing.11 In line with the increase in theunemployment rate, real GDP falls about 8½ percentfrom its pre-recession peak, reaching a trough in the third quarter of 2021.

Fed Stress Test 2020. Unemployment

The decline in activity isaccompanied by a lower headline consumer priceindex (CPI) inflation rate, which falls to an annual rate of about 1¼ percent after the first quarter of 2020, before gradually rising to average 1¾ percentin 2022.In line with the severe decline in real activity, the interest rate for 3-month Treasury bills immediately falls near zero and remains at that level through theend of the scenario.

Fed Stress Test 2020. GDP Houses

The 10-year Treasury yield immediately falls to ¾ percent during the first quar-ter of 2020 and rises gradually thereafter to 2¼ per-cent by the end of the stress-test period. The result isa gradual steepening of the yield curve over most ofthe stress-test period.

Financial conditions in corpo-rate and real estate lending markets are stressed severely. The spread between yields on investment-grade corporate bonds and yields on long-termTreasury securities widens to 5½ percentage pointsby the third quarter of 2020, an increase of 4 per-centage points relative to the fourth quarter of 2019. The spread between mortgage rates and 10-yearTreasury yields widens to 3½ percentage points overthe same period

Fed Stress Test 2020. Unemployment

Asset prices drop sharply in this scenario. Equityprices fall 50 percent through the end of 2020,accompanied by a rise in the U.S. Market VolatilityIndex (VIX), which reaches a peak of 70. Houseprices and commercial real estate prices also experi-ence large overall declines of about 28 percent and 35 percent, respectively, during the first nine quartersof the scenario.

The international component of this scenario fea-tures sharp slowdowns in all country blocs, leadingto severe recessions in the euro area, the UnitedKingdom, and Japan and a pronounced decelerationof activity in developing Asia. As a result of thesharp contraction in economic activity, three of theforeign economies included in the scenario—theeuro area, Japan, and developing Asia—experiencesharp declines in inflation rates. The U.S. dollarappreciates against the euro, the pound sterling, andthe currencies of developing Asia, but depreciatesmodestly against the yen because of flight-to-safetycapital flows.

 Fed Stress Test 2020. Loan Loss Rates

Source: Federal Reserve

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