Following the preliminary results of the Federal Reserve’s annual stress test of the country’s largest bank holding companies (BHCs) last week, banks that are determined to be well-capitalized (those with capital exceeding the Fed’s required 3% supplemental leverage ratio) can make dividend payments and stock buybacks based on the value of assets exceeding the 3% minimum threshold.
Two major financial institutions, Goldman Sachs and Morgan Stanley, only barely passed, with supplementary leverage ratios equal to 3.1% and 3.3%, respectively. These two banks can now only distribute dividends to shareholders based on 0.1% and 0.3% of assets, respectively.
The results of the test are good news for the financial system and great news for banks. On top of the clear benefits of a well-capitalized (or at least better-capitalized) banking system for macroprudential policy, increasing dividend payments makes equity more attractive to investors, making this less-risky form of raising capital easier for BHCs. Of course, if a bank decides to redistribute these gains to shareholders, it becomes less capitalized, making increased dividend payments a double-edged sword.
We see a similar dynamic with stock buybacks. They raise equity prices by increasing demand, but purchasing shares means the bank is reducing its capital cushion.
The best way these BHCs could use the windfall of the past two years would be to deleverage by either holding onto their capital or buying back debt. Unfortunately, economic research shows shareholders have strong incentives against deleveraging, especially if they are already highly-leveraged (called the “leverage ratchet effect”).
If BHCs can’t be counted on to deleverage themselves, policy change is necessary to wind down the leverage of the financial sector. Limiting the ability of banks to pay out dividends or buy back shares is one way of doing this, but there are benefits to such practices (or at a least there’s a reasonable debate to be had).
Simply raising capital requirements would be better. This would preserve BHCs’ option to make buybacks or dividend payments and, more importantly, minimize the risk of a downturn turning into a financial crisis that necessitates government intervention.
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