Fed Allows Banks To Restart Buybacks After 2nd Stress Test
Fri, 12/18/2020 – 16:37
Update: That didn’t take long. JPMorgan just announced it would maintain its dividend and buy back $30 billion in shares, sending JPM up 5% after hours…
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Bank stocks are up after hours following a statement from The Fed that the largest U.S. banks remain strong enough to survive the coronavirus crisis but warned that a prolonged economic downturn could saddle them with hundreds of billions of dollars in losses on soured loans.
Most critically for investors, The Fed said it would allow the banks to restart share buybacks but that it would, at least in the first quarter, restrict the amount. It also said it would continue to restrict dividend payouts.
Still, that was enough to break the stocks out of their recent range.
This has pushed financial stocks back to their highest since February…
The Federal Reserve Board on Friday released a second round of bank stress test results this year, which showed that large banks had strong capital levels under two separate hypothetical recessions.
“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.
The Board’s stress tests help ensure that large banks can support the economy during economic downturns. The tests evaluate the resilience of large banks by estimating their losses, revenue, and capital levels—which provide a cushion against losses—under hypothetical scenarios over nine future quarters.
Earlier this year, the Board conducted its annual stress test and additional analysis in light of the COVID event. Those results found that banks generally had strong levels of capital, but considerable economic uncertainty remained. In response, the Board put several restrictions in place to ensure that banks would preserve capital, including suspending share repurchases and limiting dividends. With the restrictions in place, large banks have recently built capital, despite setting aside about $100 billion in loan loss reserves.
This stress test includes two hypothetical scenarios with severe global recessions. The first scenario featured an unemployment rate that spiked to 12.5 percent and then declined to about 7.5 percent, while the second scenario included a peak unemployment rate of 11 percent followed by a more modest decline to 9 percent.
Under both scenarios, large banks would collectively have more than $600 billion in total losses, considerably higher than the first stress test this year. However, their capital ratios would decline from an average starting point of 12.2 percent to 9.6 percent in the more severe scenario, well above the 4.5 percent minimum. All firms’ risk-based capital ratios would remain above the required minimum.
In light of the ongoing economic uncertainty and to preserve the strength of the banking sector, the Board is extending the current restrictions on distributions, with modifications.
For the first quarter of 2021, both dividends and share repurchases will be limited to an amount based on income over the past year. If a firm does not earn income, it will not be able to pay a dividend or make repurchases.
Additionally, the firms’ capital requirements will not be reset at this time. With the current capital requirements and distribution restrictions in place, banks have built capital over the past year. The modified restriction will continue to preserve capital and ensure that large banks can still lend to households and businesses.
The Board will continue to evaluate the resiliency of large banks and monitor financial and economic conditions.
According to the Fed, the results of the December stress test suggest that, in the aggregate, the 33 firms would experience substantial losses and lower revenues under the hypothetical recessions but could continue lending to creditworthy businesses and households. This is due, in large part, to the substantial buildup of capital since the 2007–09 financial crisis and more than a doubling of loan-loss reserves during the first half of 2020. In aggregate, capital ratios remain well above their required minimum levels throughout the projection horizon under both scenarios.
In the severely adverse scenario, the aggregate CET1 ratio falls from an actual value of 12.2 percent in the second quarter of 2020 to a projected minimum of 9.6 percent before rising to 10.2 percent at the end of the third quarter of 2022. In the alternative severe scenario, the aggregate CET1 ratio declines to a minimum of 9.7 percent, but rises to 9.9 percent at the end of the third quarter of 2022. The declines in capital ratios, both in the aggregate and for individual individual firms, do not include the effect of common stock dividend distributions.
For the December stress test, aggregate losses over the projection horizon at the 33 firms are projected to be $629 billion under the severely adverse scenario and $612 billion under the alternative severe scenario. For the June stress test, total losses under the severely adverse scenario were $550 billion for the same 33 firms.
Despite higher loan losses compared to the June stress test, projected provisions for loan losses are smaller. Provisions are projected to be $429 billion under the severely adverse scenario and $440 billion under the alternative severe scenario, while provisions were $489 billion for the June stress test. This difference reflects a significant increase in firms’ loan-loss reserves since the beginning of the year. If firms had maintained the same level of loan-loss reserves as in the fourth quarter of 2019, projected provisions would be about $100 billion higher for both scenarios in this stress test.
And here is what the Fed considers a “Severely Adverse Scenario”
Figures 3 through 8 illustrate the trajectories for some of the key variables describing U.S. economic activity and asset prices under the severely adverse scenario.
The severely adverse scenario is characterized by a severe decline in global economic activity accompanied by financial market distress. Consistent with the Scenario Design Framework, under the severely adverse scenario, the U.S. unemployment rate climbs to a peak of 12½ percent in the fourth quarter of 2021, a 3 percentage point increase relative to the initial level, the level in the third quarter of 2020. In line with the increase in the unemployment rate, real GDP falls 3¼ percent from the end of the third quarter of 2020 to its trough in the fourth quarter of 2021. The decline in activity is accompanied by a lower headline consumer price index (CPI) inflation rate, which quickly falls to an annual rate of about 1¼ percent in the fourth quarter of 2020, and then ranges from 1¼ percent to about 2¼ percent in the remaining quarters.
Consistent with the severe decline in real activity, the interest rate for 3-month Treasury bills remains near zero throughout the scenario period. The 10-year Treasury yield rises gradually from about ¼ percent during the fourth quarter of 2020 to about 1½ percent by the end of the scenario period. The result is a steepening of the yield curve over the scenario period.
Financial conditions in corporate and real estate lending markets are stressed significantly. The spread between yields on investment-grade corporate bonds and yields on long-term Treasury securities widens to almost 5¾ percentage points before narrowing to about 1¾ percentage points at the end of the scenario period. The spread between mortgage rates and 10-year Treasury yields widens to about 3½ percentage points early in 2021 before gradually falling to about 1¾ percentage points by the end of the scenario.
Asset prices drop sharply in this scenario. Equity prices decline more than 30 percent from the third to the fourth quarter of 2020, as the economy contracts sharply, and the U.S. Market Volatility Index (VIX) rises to a peak level of 70. Equity prices continue to fall in the first half of 2021 before gradually recovering, leaving them down about 23 percent for the year. They continue to recover but close the scenario period down about 4¾ percent from their value in the initial quarter. House prices and commercial real estate (CRE) prices also experience large declines. House prices fall about 26¾ percent from the third quarter of 2020 to the third quarter of 2022; from that trough, they rise about 4½ percent during the rest of the scenario period. CRE prices decline 30 percent from the third quarter of 2020 to the fourth quarter of 2022 and stay close to that level for the remainder of the scenario period.
The international component of this scenario features sharp slowdowns in all developed country blocs, leading to recessions in the euro area, the United Kingdom, and Japan. Developing Asia has only a mild slowdown in economic activity in the scenario. With the continued weakness in economic activity, all of the foreign economies included in the scenario experience sizable declines in their inflation rates during the scenario period. The U.S. dollar appreciates against the euro, the pound sterling, and the currencies of developing Asia, but depreciates slightly against the yen, reflecting flight-to-safety capital flows.
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Full Stress Test Report (pdf link):