On June 25, 2020, the Federal Reserve Board (the “Fed”) released (i) the results of its supervisory stress tests for 2020; and (ii) aggregate, not bank-specific, results of a special “sensitivity analysis” conducted under a range of “plausible downside scenarios” related to the COVID-19 pandemic. The sensitivity analyses included the 33 banking organizations that were subject to the 2020 supervisory tests.
Significantly, for at least the third quarter of 2020, the Fed will, with respect to the banking organizations that were subject to these tests: (1) prohibit most forms of share repurchases; (2) cap the growth of dividends and impose a limit not to exceed recent income; (3) require them to re-assess their capital needs and resubmit their capital plans “later this year,” and (4) conduct additional stress analyses, also “later this year,” as data become available and as economic conditions evolve. The timing of the resubmission of the capital plans and the stress analyses was not specified in the Fed's release.
In a speech on June 19, 2020, Vice Chair for Supervision Randal K. Quarles noted that some banks may need, for purposes of compliance with the securities laws, to publicly disclose their stress capital buffer requirement before the Fed publicly releases this information later in the year. Vice Chair Quarles stated that the Fed expects banks to wait until after U.S. markets close on June 29, 2020 to publicly disclose any information about their planned capital actions and stress capital buffer requirements. This would provide banks sufficient time to understand their stress test results and make any necessary changes to their capital plans and “will provide for more orderly dissemination of information to the public.” The Fed made clear in its release that the sensitivity analyses do not incorporate the potential effects of government stimulus payments and expanded unemployment insurance. Likewise, however, as Governor Brainard has noted, the next round of stress tests could reflect more complete information regarding the credit quality of commercial real estate (CRE) loans and fully incorporate changes in indexes of CRE prices, rents, and vacancy rates over the first half of 2020.
The Fed conducted a sensitivity analysis to assess the potential negative effects of the economic conditions caused by the COVID-19 pandemic on large banking organizations. The analysis, which did not incorporate the potential effects of government stimulus payments and expanded unemployment insurance, consisted of the following downside scenarios:
- a rapid “V-shaped recovery” that regains much of the output and employment lost by the end of 2020;
- a slower, more “U-shaped recovery” in which only a small share of lost output and employment is regained in 2020; and
- a “W-shaped” double dip recession with a short-lived recovery followed by a severe drop in activity later in 2020 due to a second COVID event.
In three scenarios, the unemployment rate peaks at between 15.6% and 19.5%. The V-shaped scenario contemplates a deep recession in the first two quarters of the scenario and then a sustained recovery in 2021 and 2022, and assumes a peak unemployment rate of 19.5%. The U-shaped recovery assumes a prolonged social distancing to combat ongoing outbreaks of the virus across the country and a sustained peak unemployment rate of about 15.5%. Lastly, the W-shaped recovery assumes a second COVID event beginning in late 2020 and leading to a second increase in unemployment and drop in GDP. This scenario assumes a decrease in the annualized growth rate of real GDP as low as -37.5% in the second quarter of 2020, and a rise in the unemployment rate to 16% in the same quarter. Following an almost complete recovery, in the first quarter of 2021, real GDP dips again, and the unemployment rate rises back to 14%. According to the Fed, most banks remain well-capitalized under the U- and W-shaped scenarios, but several would approach minimum capital levels. The V-shaped scenario is comparable to the full stress test designed before the coronavirus, and under that stress test, all large banks remain strongly capitalized.
Near-Term Requirements and Prohibitions
In its effort to continuously monitor the ever-changing economic environment due to the COVID-19 pandemic, the Fed is requiring banking organizations subject to its capital plan rule to resubmit capital plans within 45 days after the Fed provides updated scenarios. Accordingly, banking organizations will be prohibited from making any capital distribution (excluding any capital distribution arising from the issuance of a capital instrument eligible for inclusion in the numerator of a regulatory capital ratio), unless otherwise approved by the Fed. The Fed is authorizing each banking organization to conduct the following activities through the end of the third quarter of 2020:
- conduct share repurchases relating to issuances of common stock related to employee stock ownership plans;
- pay common stock dividends that do not exceed an amount equal to the average of the firm's net income for the four preceding calendar quarters, unless otherwise specified by the Fed and so long as the banking organization does not increase the amount of its common stock dividends; and
- make scheduled payments on additional Tier 1 and Tier 2 capital instruments.
The Fed may extend these measures on a quarter-by-quarter basis, as economic conditions caused by the COVID-19 pandemic continue to evolve.
Originally published by Shearman & Sterling, June 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.