Federal Reserve caps bank dividends

The Federal Reserve told the biggest U.S. banks they can’t increase dividends or resume buybacks through at least the third quarter as uncertainty over the course of a global pandemic weighs on lenders.

The industry performed well in annual stress tests, according to a statement Thursday from the central bank, but a separate review of the effects of the coronavirus on the economy and financial system uncovered potential risks that left the fate of their dividends in question.

The Fed “is taking action to assess banks’ conditions more intensively and to require the largest banks to adopt prudent measures to preserve capital in the coming months,” Fed vice chairman for supervision Randal Quarles said in the statement. “The banking system remains well capitalized under even the harshest of these downside scenarios.”

The Fed capped dividends at second-quarter levels and said future payouts would be limited by a formula based on recent earnings.

That left Wells Fargo & Co., whose profits slumped 89% in the first quarter, most at risk for a dividend cut. Earnings power at the company has declined with the economic meltdown and, unlike many of its competitors, Wells Fargo doesn’t have a sizable trading operation benefiting from market volatility. Under the new rule, a bank’s dividend can’t exceed average quarterly earnings for the previous four quarters.

There’s still a chance Wells Fargo can continue paying a dividend. Assuming its second-quarter income is as low as in the first three months of the year, its average for the past four quarters would be $2.2 billion, higher than the $2.1 billion the bank paid in dividends in the first quarter.

GOLDMAN, MORGAN STANLEY

Goldman Sachs Group Inc. and Morgan Stanley fared the worst among U.S.-based banks in the regular portion of the stress tests, with their capital levels declining 6.4 and 5.5 percentage points, respectively, under a hypothetical economic crisis devised by the Fed.

Both companies were expected to do worse than other banks because their businesses are more reliant on capital markets, which take a heavier beating in the regulator’s crisis scenario.

Representatives of Goldman Sachs and Morgan Stanley declined to comment on the stress tests, and Wells Fargo said it had no immediate comment.

The central bank is also requiring banks to resubmit capital plans later in the year, a move unprecedented in the past decade of Fed testing. Quarles said the board “will use this information to make a further assessment of the banks’ financial conditions and risks.”

Alison Williams, an analyst at Bloomberg Intelligence, called that move a “broad negative” for banks, since it “signals more uncertainty.”

Shares of Goldman Sachs were down more than 4% in extended trading in New York at 5:24 p.m. Thursday and Well Fargo slumped 3.5%. Morgan Stanley was virtually unchanged.

‘NOT TOO HARSH’

Analysts weren’t expecting buybacks to resume any time soon or that any bank would be able to boost dividends. Keefe Bruyette & Woods said JPMorgan Chase & Co. and Citigroup Inc. might even see dividend cuts resulting from a new “sensitivity analysis” the Fed used to gauge the impact of the pandemic. Morgan Stanley analysts had said Goldman’s payout was under threat.

“This is not as drastic as it sounds as dividends are basically being preserved and buybacks were off the table anyway,” said Adam Gilbert, head of the financial services advisory practice at PricewaterhouseCoopers. “Initially it’s not too harsh.”

The sensitivity analysis sought to capture how financial firms are positioned to handle financial pressure caused by the pandemic. Those results were only released in aggregate form, showing how all the 34 banks being tested would fare under more severe scenarios.

Policy makers considered three potential scenarios. Results from the quick-recovery, V-shaped outcome echoed those of the regular stress tests, with the aggregate capital level of the firms dropping by 2.5 percentage points versus 2.1 in the analysis that didn’t take into account the pandemic.

But a slower recovery would mean a much harsher impact, with the group’s capital declining 3.9 percentage points in the U-shaped rebound and 4.3 percentage points in the longest, W-shaped scenario, which assumes a second wave of coronavirus containment measures.

BRAINARD OBJECTS

Fed Governor Lael Brainard said in light of the potential risk of an even more severe downturn, it was a mistake to let banks keep paying dividends.

“Despite the substantial likelihood that banks will need larger capital buffers to absorb losses under plausible scenarios, the authorization permits distributions that will deplete capital buffers,” Brainard said in a separate statement.

In the past, the nation’s largest banks would disclose their buyback and dividend targets for the next 12 months within minutes of the Fed’s announcement of stress test results. But this time, policy makers asked them not to release capital distribution plans until Monday.

Immediate decisions on distributions aren’t possible anyway because of changes to the exam. For one, capital plans are no longer directly approved by the Fed during the stress test. Instead, regulators assign each company a “capital buffer” based on their performance in the review. Each bank then has the freedom, without prior Fed approval, to distribute cash to shareholders as long as they stay within required minimums.

Adding another layer of complexity to the calculation was the addition of the side tests related to the impact of the pandemic. Bank officials are seeing those results for the first time Thursday, and will need time to adjust their payout targets before making them public.

POLITICAL PRESSURE

The stress tests, begun in 2009 as a tool to help avoid another financial crisis, examine the biggest banks’ ability to weather extreme economic downturns without the need for government bailouts. They have been the single most important factor determining how much capital Wall Street banks need to ward off another disaster.

In a letter earlier this week, Democratic senators including Sherrod Brown and Elizabeth Warren urged the central bank to “bolster the resilience of the banking system in the face of a deeply uncertain negative outlook and implement an across-the-board suspension on bank dividends and discretionary bonus payments.”

The largest U.S. lenders suspended buybacks in March until the end of the second quarter to conserve capital for the pandemic. Analysts aren’t expecting them to resume until the middle of next year.

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