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Fed Unveils 2nd Stress Test Results, Eases Capital Distribution Limits
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On Friday, the Federal Reserve announced the second round of bank stress test results this year, which, to a great extent, reflect the stability of the banking system. In fact, this reaffirms that U.S. banking giants are adequately capitalized to survive under tremendously-difficult economic scenarios. Remarkably, the test, conducted under two separate hypothetical recessions, reflected the resiliency of banks.
"The banking system has been a source of strength during the past year and 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," said vice chair for supervision Randal K. Quarles.
Root of the Stress Test
Currently authorized under the Dodd-Frank financial-services law, stress tests were introduced after the 2008 financial crisis. During the then economic downturn, big financial institutions like Lehman Brothers collapsed and several other big banks were also on the verge of a similar disaster. The situation compelled the U.S. government to infuse billions of dollars into credit markets and save the entire financial system from crashing. Stress tests have been annually conducted since 2009. Notably, this was the first time that the central bank conducted the stress test twice in a year amid the pandemic to decide major banks’ capital adequacy and payouts.
Details Under New Hypothetical Scenarios
This June, the Fed announced the results of 2020 stress test, which highlighted the banking system’s financial stability. Taking into account the pandemic-induced mayhem, the central bank had tested banks on three recovery scenarios — ‘V-shaped’, ‘U-shaped’ and ‘W-shaped’ — to decide banks’ capital adequacy and payouts. The results showed that in the last two scenarios, most firms would still be able to remain well capitalized, while several will touch minimum capital levels. Meanwhile, the V-shaped scenario results came in similar to the severely-adverse scenario.
Therefore, the regulator suspended buyback programs for the third quarter of 2020 and also put a limit on dividend distributions to preserve capital. Apart from this, large banks were required to resubmit their payout plans. With restrictions imposed, large banks were able to build capital despite setting aside around $100 billion in loan loss reserves.
Further, this October, the Fed extended restrictions on dividends and share buybacks by big U.S. banks. The central bank restricted share buybacks for another three months — the period till the end of the fourth quarter. In addition, dividends were capped and based on the formula related to a bank’s recent income. Under the restrictions, banks were not allowed to pay dividends more than their average quarterly profit from the four most recent quarters.
Under the second round, the Fed came up with two hypothetical scenarios — “severely adverse” and “alternative severe” — to test the resilience of the major banks for nine quarters into the future. The “severely adverse” scenario included unemployment rate peaking at 12.5% at the end of 2021 and then declining to 7.5% by the end of the scenario; GDP declining approximately 3% from third-quarter 2020 through fourth-quarter 2021. It also featured a substantial global slowdown.
Under “alternative severe” scenario, the economy will decline 2.5% from the third quarter to the fourth quarter of 2020. Further, the unemployment rate will peak at 11% by 2020-end and fall only to 9% by the end of the scenario.
Also, these two scenarios included a global market shock component, which was applied to banks with large trading businesses. Furthermore, these banks, along with those with substantial processing operations, were required to add the default of their largest counterparty.
Under both scenarios, large banks were expected to have more than $600 billion in total losses, significantly above the first stress test this year. However, their capital ratios were projected to decline from an average 12.2% to 9.6% in the more severe scenario, well above the minimum level of 4.5%. Also, risk-based capital ratios of all banks were projected to be above the minimum required level.
Outcome of Second Round of Stress Test
Considering the ongoing economic uncertainty triggered by the COVID-19 pandemic and to preserve the banking sector’s strength, the existing restrictions on distributions of capital by banks has been extended by the Fed but with some modifications. For the first quarter of 2021, banks have been permitted for capital deployment, including both dividends and share repurchases, but limited to the amount based on income over the past year. Markedly, on failure of earning an income, that bank will not be allowed to for paying dividend or share repurchases.
Additionally, without re-setting the capital requirements of banks and with modified restriction, the Federal Reserve views the preservation of capital to continue, with large banks in position to lend to households and businesses. Notably, to maintain capital adequacy, the evaluation of the resiliency of large banks and monitoring of financial and economic conditions will be continued by the central bank.
After-Effects of the Results
Following the easing out of restrictions on capital distribution by the Fed, many large banks came out with their buyback announcements that will start in the first quarter of 2021. Among others, JPMorgan (JPM - Free Report) and Morgan Stanley (MS - Free Report) have already announced their capital plans, while Citigroup (C - Free Report) , Goldman Sachs (GS - Free Report) , Bank of New York Mellon (BK - Free Report) , Wells Fargo (WFC - Free Report) and State Street (STT - Free Report) are expected to announce soon.
Conclusion
With banks taking measures to strengthen their financials and confront challenges, the stress test will further help regulators check their progress in the same and avert another crisis. Further, this will boost the lending capacity of banks, thereby bolstering their financial positions.
Though an economic uncertainty lingers due to the prevalent health crisis; at present, banks are actively responding to every legal and regulatory pressure. This has, in fact, positioned banks well to encounter impending challenges.
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Fed Unveils 2nd Stress Test Results, Eases Capital Distribution Limits
On Friday, the Federal Reserve announced the second round of bank stress test results this year, which, to a great extent, reflect the stability of the banking system. In fact, this reaffirms that U.S. banking giants are adequately capitalized to survive under tremendously-difficult economic scenarios. Remarkably, the test, conducted under two separate hypothetical recessions, reflected the resiliency of banks.
"The banking system has been a source of strength during the past year and 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," said vice chair for supervision Randal K. Quarles.
Root of the Stress Test
Currently authorized under the Dodd-Frank financial-services law, stress tests were introduced after the 2008 financial crisis. During the then economic downturn, big financial institutions like Lehman Brothers collapsed and several other big banks were also on the verge of a similar disaster. The situation compelled the U.S. government to infuse billions of dollars into credit markets and save the entire financial system from crashing. Stress tests have been annually conducted since 2009. Notably, this was the first time that the central bank conducted the stress test twice in a year amid the pandemic to decide major banks’ capital adequacy and payouts.
Details Under New Hypothetical Scenarios
This June, the Fed announced the results of 2020 stress test, which highlighted the banking system’s financial stability. Taking into account the pandemic-induced mayhem, the central bank had tested banks on three recovery scenarios — ‘V-shaped’, ‘U-shaped’ and ‘W-shaped’ — to decide banks’ capital adequacy and payouts. The results showed that in the last two scenarios, most firms would still be able to remain well capitalized, while several will touch minimum capital levels. Meanwhile, the V-shaped scenario results came in similar to the severely-adverse scenario.
Therefore, the regulator suspended buyback programs for the third quarter of 2020 and also put a limit on dividend distributions to preserve capital. Apart from this, large banks were required to resubmit their payout plans. With restrictions imposed, large banks were able to build capital despite setting aside around $100 billion in loan loss reserves.
Further, this October, the Fed extended restrictions on dividends and share buybacks by big U.S. banks. The central bank restricted share buybacks for another three months — the period till the end of the fourth quarter. In addition, dividends were capped and based on the formula related to a bank’s recent income. Under the restrictions, banks were not allowed to pay dividends more than their average quarterly profit from the four most recent quarters.
Under the second round, the Fed came up with two hypothetical scenarios — “severely adverse” and “alternative severe” — to test the resilience of the major banks for nine quarters into the future. The “severely adverse” scenario included unemployment rate peaking at 12.5% at the end of 2021 and then declining to 7.5% by the end of the scenario; GDP declining approximately 3% from third-quarter 2020 through fourth-quarter 2021. It also featured a substantial global slowdown.
Under “alternative severe” scenario, the economy will decline 2.5% from the third quarter to the fourth quarter of 2020. Further, the unemployment rate will peak at 11% by 2020-end and fall only to 9% by the end of the scenario.
Also, these two scenarios included a global market shock component, which was applied to banks with large trading businesses. Furthermore, these banks, along with those with substantial processing operations, were required to add the default of their largest counterparty.
Under both scenarios, large banks were expected to have more than $600 billion in total losses, significantly above the first stress test this year. However, their capital ratios were projected to decline from an average 12.2% to 9.6% in the more severe scenario, well above the minimum level of 4.5%. Also, risk-based capital ratios of all banks were projected to be above the minimum required level.
Outcome of Second Round of Stress Test
Considering the ongoing economic uncertainty triggered by the COVID-19 pandemic and to preserve the banking sector’s strength, the existing restrictions on distributions of capital by banks has been extended by the Fed but with some modifications. For the first quarter of 2021, banks have been permitted for capital deployment, including both dividends and share repurchases, but limited to the amount based on income over the past year. Markedly, on failure of earning an income, that bank will not be allowed to for paying dividend or share repurchases.
Additionally, without re-setting the capital requirements of banks and with modified restriction, the Federal Reserve views the preservation of capital to continue, with large banks in position to lend to households and businesses. Notably, to maintain capital adequacy, the evaluation of the resiliency of large banks and monitoring of financial and economic conditions will be continued by the central bank.
After-Effects of the Results
Following the easing out of restrictions on capital distribution by the Fed, many large banks came out with their buyback announcements that will start in the first quarter of 2021. Among others, JPMorgan (JPM - Free Report) and Morgan Stanley (MS - Free Report) have already announced their capital plans, while Citigroup (C - Free Report) , Goldman Sachs (GS - Free Report) , Bank of New York Mellon (BK - Free Report) , Wells Fargo (WFC - Free Report) and State Street (STT - Free Report) are expected to announce soon.
Conclusion
With banks taking measures to strengthen their financials and confront challenges, the stress test will further help regulators check their progress in the same and avert another crisis. Further, this will boost the lending capacity of banks, thereby bolstering their financial positions.
Though an economic uncertainty lingers due to the prevalent health crisis; at present, banks are actively responding to every legal and regulatory pressure. This has, in fact, positioned banks well to encounter impending challenges.
Breakout Biotech Stocks with Triple-Digit Profit Potential
The biotech sector is projected to surge beyond $775 billion by 2024 as scientists develop treatments for thousands of diseases. They’re also finding ways to edit the human genome to literally erase our vulnerability to these diseases.
Zacks has just released Century of Biology: 7 Biotech Stocks to Buy Right Now to help investors profit from 7 stocks poised for outperformance. Our recent biotech recommendations have produced gains of +50%, +83% and +164% in as little as 2 months. The stocks in this report could perform even better.
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