The Federal Reserve will lift the ban on stock buybacks by large banks in the first quarter of 2021, but it will also limit those buybacks to an amount based on profits in 2020.
The Fed also said dividend payouts would be limited to an amount based on income over the past year, so if a firm did not earn any income in 2020, it will not be able to pay out dividends or conduct share repurchases. Lastly, the Fed said it would not adjust capital requirements for banks right now.
"The modified restriction will continue to preserve capital and ensure that large banks can still lend to households and businesses," the Fed said in a statement.
Stress testing is an exercise where the Fed puts large U.S. banks with more than $100 billion in assets through hypothetical economic scenarios to see how they would hold up during an economic downturn. The goal is to ensure the safety and soundness of the banking system and make sure that banks can continue to lend during hard times.
In this recent round of stress testing, the Fed put banks through two scenarios. In one severely adverse scenario, unemployment peaked at 12.5% at the end of 2021, and then declined to about 7.5%. Gross domestic product dropped by 3% between the third quarter of 2020 and the fourth quarter of 2021. In the alternative severely adverse scenario, unemployment would rise more rapidly to 11% by the end of 2020 but stay higher and only decline to 9% by the end of the scenario. GDP would decline 2.5% in the fourth quarter of this year.
The Fed said that in both scenarios, the 33 banks put through the test would collectively rack up more than $600 billion in total losses. However, their capital ratios would hold up fairly well, dropping from an average starting point of 12.2% to 9.6% in the toughest scenario, well above their required capital minimums. And each would keep their capital ratios above their required minimums.
The central bank conducted a first round of stress testing earlier this year, running banks through its standard stress-testing scenarios and also some additional coronavirus-related scenarios. Banks proved to be generally well capitalized.
However, due to such uncertainty, the Fed restricted stock buybacks for large banks and also put restrictions on dividend payouts. They also required this recent second round of stress testing.
The big takeaway for investors here is that most large banks will be able to start doing some level of share repurchases in the first quarter of 2021, and that should help their stock prices.
Additionally, you can all but rule out the Fed's alternative severely adverse scenario, as unemployment in November hit 6.7%. With just weeks remaining in 2020, it is very unlikely to increase to 11% before the end of the year.