A member of the Federal Reserve’s board of governors has voiced concern over the decision to allow large banks to continue to pay dividends during the COVID-19 pandemic.
Governor Lael Brainard, one of five members of the Fed’s board, warned that distributions to shareholders would “deplete capital buffers” at the same time that the central bank’s forecasts have shown that US banks could suffer up to $700 billion in losses if the country experienced a double-dip recession.
“Using backward-looking earnings as the basis for payouts in a forward-looking capital framework is problematic at a time when future earnings are likely to decline and required buffers are likely to rise,” Brainard said.
“This action creates a significant risk that banks will need to raise capital or curtail credit at a challenging time.”
The Fed has placed a limit on bank dividends for the third quarter of 2020, meaning they cannot pay out more than in the second quarter or higher than their average total dividend across the past four quarters.
It has also banned share buybacks for the third quarter. Both measures are temporary but could be extended, the central bank said last week.
The limits were introduced following the results of the Fed’s latest Dodd-Frank Act Stress Test of the US’s largest banks. While all 33 banks assessed passed the test, the central bank warned that a U-shaped recovery or a douple-dip recession could have a severe negative effect on bank balance sheets given higher loan losses and income pressures.
Brainard said previous stress tests had been criticized for being “excessive and unrealistic”, but highlighted that the actual impact of the pandemic had “far exceeded” its worst-case scenario.
“Moreover, the actual market shock in the first quarter of 2020 was similar in magnitude to the first quarter of the 2020 stress test scenario,” she added.
“The forward-looking sensitivity analysis indicates that many large banks are likely to need greater loss absorbing capital to avoid breaching their buffers in adverse circumstances next year,” Governor Brainard continued.
“The wide range of loss rates and capital ratio outcomes in the sensitivity analysis reflects the unprecedented amount of uncertainty clouding the outlook. The banks themselves have noted the high level of uncertainty, and forecasters have placed a fair amount of weight on outcomes similar to the U- or W-shaped scenarios.”
These scenarios suggested that a quarter of banks “could be close to their minimum requirements”, she warned.
“Past experience shows that banks operating close to their regulatory minimums are much less likely to meet the needs of creditworthy borrowers, and the resulting tightening of credit conditions could impair the recovery,” Brainard said.
Fellow board member Randal Quarles, the Fed’s vice-chair for supervision, maintained that the US banking system was “well capitalized under even the harshest of these downside scenarios – which are very harsh indeed”.
Quarles acknowledged the “material uncertainty” over the economic recovery, and said the Fed would “take additional policy actions” to support banks and the economy if needed.