The Federal Reserve announced the results of its 2020 bank stress tests on Thursday, and in some ways, the results were rather encouraging. Even under some extremely severe hypothetical scenarios -- such as unemployment peaking at 19.5% and a long U- or W-shaped recovery -- most big banks would remain well-capitalized.
However, the bad news is that under some of the recession scenarios, loan losses would be as high as $700 billion across the 33 banks subject to the tests due to elevated and prolonged unemployment, and this could cause some (but not most) of the banks to approach minimum capital levels.
Bank dividends could be restricted
In its press release, the Federal Reserve said that banks will not be allowed to repurchase any stock during the third quarter, and all of the banks will be required to resubmit their capital plans later in 2020.
Dividends can still be paid in the third quarter, but no dividend increases will be allowed. And in order to pay any dividends, banks must have sufficient income. The Fed is only allowing banks to pay dividends according to a formula based on recent earnings. Specifically, dividends cannot exceed the average of the bank's net income for the four previous calendar quarters -- so if the recession makes a bank unprofitable, a dividend cut is a real possibility.
This isn't a prediction -- it's a "what if"
To be clear, none of the scenarios tested by the Federal Reserve are especially likely. The point is to see how the banks would fare in some pretty awful circumstances. And, the stress tests assumed no further economic stimulus payments or expanded unemployment insurance, both of which are likely to happen -- especially if the recession gets far worse than expected.
For the most part, the test results look strong -- but for the time being, the Fed just wants to make sure that bank stocks only pay dividends if they can safely afford to do so, no matter what happens in the economy over the next few quarters.