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Stress Test to Allow Banks to Lift Curb on Dividend & Buybacks

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The Federal Reserve will come out with 2021 stress test results soon. Similar to last year, major banks are expected to clear the same. This is likely to pave the way for removal of limits on banks’ dividends and share repurchases that were in place since last year.

The annual stress test, which begun following the 2008 financial crisis, helps understand how major banks like JPMorgan (JPM - Free Report) , Bank of America (BAC - Free Report) , Citigroup (C - Free Report) and Goldman Sachs (GS - Free Report) would fare in an extremely hypothetical economic downturn.

This year’s hypothetical scenarios — Baseline and Severely Adverse — were revealed in February. It covered 13 quarters through the first quarter of 2024.

This year, 19 major banks, with more than $250 billion in assets, are part of the annual exercise. Of these, 10 with the large trading operations are being tested against a hypothetical global market shock, while 12 with significant trading or processing operations will be tested against the failure of their largest counterparty too.

In 2020, banks faced real-life economic shocks due to the coronavirus pandemic, which by many measures were more extreme than the Fed’s hypothetical scenarios. Despite facing a tough operating backdrop, banks were able to clear two rounds of stress tests (in June and December).

Nonetheless, in June 2020, the central bank put limits on banks’ capital distributions (maintaining dividend payouts and suspending repurchases) so that it doesn’t exceed their recent profits. This was done to preserve liquidity owing to the economic uncertainty.

Thus, few banks like Capital One (COF - Free Report) and Wells Fargo (WFC - Free Report) had to cut quarterly dividends. While Capital One has already restored quarterly dividend to the pre-COVID-19 level, Wells Fargo is yet to do so.

Though some of the limits were removed following December 2020 stress test by allowing banks to resume buybacks, restrictions on dividend hike remained in place. Subsequently, many banks including JPMorgan, Morgan Stanley (MS - Free Report) , Citigroup and Wells Fargo resumed repurchases.

Further, in March this year, the central bank announced that restrictions imposed on banks’ capital distributions will be lifted by June-end. Vice Chair for Supervision Randal K. Quarles had said, “The banking system continues to be a source of strength and returning to our normal framework after this year's stress test will preserve that strength.”

Also, so far this year, KBW Nasdaq Bank Index has gained 26.5%, outperforming the S&P 500’s rally of 14.8%. The bank stock rally partly seems to be driven by expectations that major banks will easily pass the annual test.

Thus, with robust financial performance despite facing challenging operating backdrop and substantial economic slowdown last year, banks are on solid ground. Banks remain well capitalized, reflecting solid balance sheet and liquidity positions.

Banks are likely to rally further following the release of stress test results. But to know what’s actually going to happen, we will have to wait until Thursday 4.30 pm ET.

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