Big Bank Stress Is Crushing the Stock Market Today

The stock market fell sharply on Friday morning, and for once, worries about the coronavirus pandemic weren't entirely in the spotlight. While it's true that case counts have continued to rise, there was more attention being paid on Wall Street to the responses that regulatory bodies have made in light of the financial pressure from business shutdowns and other public health and safety measures. Just before 11:30 a.m. EDT, the Dow Jones Industrial Average (^DJI 0.40%) was down 528 points to 25,218. The S&P 500 (^GSPC 1.02%) was down 53 points to 3,032, and the Nasdaq Composite (^IXIC 2.02%) was lower by 163 points to 9,853.

Financial stocks were the worst performers on Friday morning, and that's because big banks took a big hit from the latest news from the Federal Reserve. This is the time of year when stress test results come out, and the Fed dropped a bombshell on the industry that could have serious ramifications for bank shareholders for the foreseeable future.

Image source: Getty Images.

What the Fed said

Each year since the financial crisis, the Fed has done stress testing of systemically important financial institutions. Late Thursday afternoon, the nation's central bank released the results of this year's tests, but added a twist not seen before.

In addition to its normal testing, the Fed also provided an analysis of how sensitive those banking institutions would be to various macroeconomic scenarios. Although many people are hoping the U.S. will experience a V-shaped economic recovery, the central bank also looked at how they'd fare under at more prolonged U-shaped path or a  double-dip, W-shaped recovery. The Fed found that if a U-shaped or W-shaped recovery were to happen, banks would generally be well-capitalized, but many would wind up near their minimum capital levels.

The Fed therefore required banks to suspend stock buybacks in the third quarter, and capped bank dividend payments at their present level, with further limitations based on recent financial results. Banks will also have to resubmit capital plans to take more specific account of the stresses that the COVID-19 pandemic has put on them and the broader economy.

Banks feel the pain

Investors in big bank stocks weren't happy with the restrictions, which will result in a significant decline in the amount of capital the companies will return to shareholders in the near term. Goldman Sachs (GS 1.79%) and Wells Fargo (WFC -0.03%) were both down 7% Friday morning, while JPMorgan Chase (JPM 0.06%), Bank of America (BAC -0.21%), and Citigroup (C 1.41%) lost 5%.

The immediate impact on shareholders will come from the suspension of share repurchases. That's more significant than many realize. Here's how much banks have spent on buybacks in the past 12 months, according to data from S&P Global Market Intelligence:

Data source: S&P Global Market Intelligence.

In addition, the Fed move is prompting more worries about future bank dividends. Income-based limitations on dividends might not force immediate cuts, but if big increases in loan reserves prove necessary in a recessionary environment, then the resulting losses could trigger reductions in payouts.

Financial stocks have already had a tough year as falling interest rates and flattening yield curves have eaten into banks' traditional sources of profit. The Fed's latest move adds just one more reason to be wary of financials right now.