The Fed Put Restriction On US Bank Dividend Payment

On Thursday, the Federal Reserve put new restrictions on the United State banking industry after the annual test revealed that some of the banks might be forced into an uncomfortable minimum capital level due to the impact of the coronavirus pandemic on the economy. The Fed stated - as part of the restrictive measure - that for the third quarter of the year, big banks would have to suspend its share buyback and cap dividend payments. Added to this, dividends would only be paid based on the recent earnings of the banks.

The Fed states that henceforth banks would be subjected to scrutiny. In fact, they are expected to resubmit their payout plan. With this occurrence, banks might rack up as much as $700 million in loan losses. This is coupled with the current increase in unemployment which is at 19.5%. Part of the reason for the hard-hit on banks is the fall in their stocks. Banks stock fell after the close of regular trading in New York. For instance, the shares of Goldman Sachs slumped 3.9%, Well Fargo (WFC) share fell 3.3% and JPMorgan Chase dropped at 1.9%

“While I expect banks will continue to manage their capital actions and liquidity risk prudently, and in support of the real economy, there is material uncertainty about the trajectory for the economic recovery,” Fed Vice Chair Randall Quarles said in a statement. “As a result, the Board 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."

The Fed moves show that the extent the coronavirus would continue to spread and how long the state economy is going to remain affected remains unknown. As it is the Fed is only trying not to allow history to repeat itself. It is trying to avoid the repetition of the huge impact of the 2007 Great recession on banks and the United States economy at large. However, before the restriction, the biggest banks in the state already decided to suspend shares repurchase, despite the fact that 70% of their profit is made from this. “These companies are effectively nationalized,” David Ellison, a portfolio manager at Hennessy Funds, said in a CNBC interview. “It sounds like buybacks aren’t going to come back for a long time, and the dividends are going to be subject to what the Fed believes the economy looks like.”

The Fed gave the banks till Monday the 29th of June to disclose their capital and reveal whether or not they were able to maintain their current dividend payout.

What Is Stress Test In Finance?

Stress testing is a computer simulation technique that is used to test the level of stability that institutions and investment portfolios have against possible future financial situations. Financial institutions use stress tests to gauge investment risk and the adequacy of assets, and also analyze internal control and processes.

While stress test is mostly used by financial institutions for internal reasons, in recent times the Fed Reserve has included this in some of the necessary reports to be submitted by the institutions. This is to ensure that the capital holding and other assets of the banks are adequate.

What Is the Bank Stress Test?

A bank stress test is a detailed financial analysis usually carried out during an unfavorable economic scenario such as a deep financial crisis. The bank stress test is used to determine the extent the banks can withstand the impact of adverse economic developments. Usually, in the United State when the asset of a bank is $50 billion or more, it will be required to conduct an internal stress test carried out by their risk management team and the federal reserve.

Bank stress test was adopted after the Great Recession of 2007-2009 which left many banks greatly under capital. The Recession reveals the vulnerability of banks and how bad they can be affected by economic downturns.

How Can Stress Test Help To Tell About The Condition Of The Economy

Generally, a stress test is used to determine the vulnerability of financial institutions to economic downturns. To achieve this, the test focus on these key areas: market risk, credit risk, and liquidity risk. The Federal Reserve set out the criterion to be used during the test and all action is carried out using computer simulation hypothetical techniques. The test is performed on a semi-annual basis.

The hypothetical situation used for the test is usually based on the real crises, for instance, the Great Recession of 2007. The test is to determine if the banks have enough capital to make it through a financial crisis for a given period of time, usually nine quarters.

Since the economy of the state is largely tied to the survival of the banks, bank testing can also determine the extent of situation such as unemployment rate of the state, plunge in home price, and fall of stocks. This is why, when banks are beginning to show vulnerability during a test, some measures are taken to help the banks withstand the crisis.