“Allowing Banks to Reduce Their Reserves of Risk-Reducing Capital”

When the pandemic sent much of Europe into lockdown this spring, banking regulators in the UK and the EU acted swiftly to pressure banks to halt dividends. But in the United States, the Fed decided against halting shareholder dividends.

The Fed did take some action: the central bank announced in late June that large US banks couldn’t pay higher dividends to their shareholders than they had paid in the second quarter of 2020 and that payments had to comply with a formula based on recent income. The Fed also temporarily halted share buybacks. In September, the Fed extended the cap on dividends and the ban on buybacks to continue until the end of 2020.

The June decision on buybacks came after the Fed announced the results of the year’s “stress test” — economic projections that the Fed is required to make annually under the 2010 Dodd-Frank Act, to survey the ability of the nation’s largest banks to withstand a crisis based on different scenarios.

The advocacy group Americans for Financial Reform said in a statement following the stress tests,

For years, the Federal Reserve has systematically weakened stress test modeling practices and assumptions used to forecast bank losses in a recession. This has the effect of allowing banks to reduce their reserves of risk-reducing capital and distribute these reserves to shareholders and executives.

Federal Reserve vice chair for supervision Randal Quarles — a Trump appointee who has pushed deregulation — said in late September that “large U.S. banks entered this crisis in strong condition, and the Fed has taken a number of important steps to help bolster banks’ resilience,” including halting stock buybacks and capping dividends.

Critics say it is absurd to allow banks to pay dividends at all when the country is experiencing an economic crisis that could still get much worse.

“This is a time for large banks to preserve capital, so they can be a source of strength in a robust recovery,” Federal Reserve Board governor Lael Brainard, an Obama appointee, said in June when she voted to halt dividends.

I do not support giving the green light for large banks to deplete capital, which raises the risk they will need to tighten credit or rebuild capital during the recovery. This policy fails to learn a key lesson of the financial crisis, and I cannot support it.

A Push to Reduce Capital Requirements That Protect Against a Collapse

Not only did Quarles vote to allow banks to continue paying dividends, but he has been pressuring Congress to reduce capital requirements below the original levels set by the Dodd-Frank Act.

In July, senators Elizabeth Warren and Sherrod Brown sent letters to Quarles and Fed chair Jerome Powell, excoriating Quarles for pressing Congress to further ease Dodd-Frank bank capital requirements.

“This change would, in effect, allow the banking regulators to reduce capital requirements below their 2008 levels — the same inadequate levels at which the banking system was once brought to the precipice of collapse,” the senators wrote in their letter to Quarles.

The letter also detailed the actions that the Fed had already taken to loosen capital requirements for banks since the outset of the crisis, which include: allowing banks to pay dividends even after cutting into their capital buffers to lend, easing rules on how much capital banks must maintain in relation to loans and other assets, and failing to halt dividends.

By lowering capital requirements while still allowing dividends, the Fed is both indicating that the economy is bad enough that banks need lower capital requirements to incentivize them to lend and strong enough that banks can still pay dividends.

Moral Hazard Strikes Again

Some Fed officials have said that halting dividend payments to shareholders would signal that regulators are concerned about the health of the financial system, and that easing capital standards will make consumer credit cheaper — helping to fund an economic recovery.

But Marcus Stanley, policy director at Americans for Financial Reform, said this isn’t a real concern.

“The idea that the Fed needs to reassure the markets by letting banks pay dividends is the kind of backward logic that you fall into if you accept Wall Street’s assumptions about what is good and what is bad,” Stanley told us. “Fed officials up to and including Powell are flashing red warning signs about what will happen absent additional fiscal stimulus. No bank dividend payment is going to obscure those signals to the market.”

Stanley added that easing capital standards won’t help consumers, because their problem right now isn’t a lack of credit, but a lack of income.

There’s also a longer-term concern associated with the Fed’s policies of allowing banks to pay dividends during a moment of immense uncertainty. A key cause of the last financial crisis was that capital requirements on banks weren’t stringent enough. And yet, the banks paid shareholder dividends until the government decided to bail them out.

It created what economists call “moral hazard,” because now banks make decisions with the knowledge that they will be bailed out when the moment comes. Knowing that they will be bailed out, bankers have stronger incentives to take risks with bank resources, leaving the economy in a more fragile state.

“Strong capital bases help avoid the problem of moral hazard in the first place,” Stanley said, adding that “dividends privatize profits without regard to whether a bank might fail in the future.”

In other words, paying out dividends privatizes bank profits by shielding the money from being seized by lenders if the bank becomes bankrupt.

The banks are now undergoing a second round of stress testing, which Quarles announced in June, meaning they are required to submit their capital plans again. This is the first time the banks have had to undergo stress testing twice in one year, but critics say the Fed is only conducting the test to send the message that the banks are fine. The results will be announced on December 18.