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Federal Reserve 'stress tests' show some banks may struggle amid the pandemic

“Regulation is tricky — because bankers want the benefit of having that backstop of the Fed, but they also want to make money,” said one economist.
Views Of The Federal Reserve As Markets Watch For Interest Rate Liftoff
The Marriner S. Eccles Federal Reserve building stands past passing vehicles in Washington.Andrew Harrer / Bloomberg via Getty Images

Bank regulators are stepping up oversight, but continue to roll back rules that are supposed to prevent a repeat of the “too big to fail” crisis that prompted massive financial industry bailouts after the Great Recession.

On Thursday, the Federal Reserve completed “stress tests” to determine whether or not banks could survive a prolonged economic downturn — and determined that the pandemic could drive some to the brink in a worst-case scenario.

The Fed told banks they aren’t allowed to buy back their own stock through the third quarter of the year, and imposed limits on how much they can pay out in dividends. Also on Thursday, the Fed — along with the Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation — relaxed the Volcker Rule, a 10-year-old restriction introduced in the wake of the financial crisis that prohibited banks from making certain risky investment bets.

“I think you've seen a greater view of a bank as more of a public utility as opposed to a private investor operation,” said Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware.

Elson said decisions about how banks use their money should rest with executives and boards. “When you have the threat of failure, people do a better job,” he said.

But others say banks are fundamentally different in that they operate more like an essential utility — and any breakdown would be catastrophic.

“For good or bad, and you have to keep the banks healthy enough play their role."

“Banks are a bit different than normal businesses. The banking sector is special in that it’s providing liquidity to the economy,” said Bryan Routledge, an associate professor of finance at Carnegie Mellon University.

The Fed has relied heavily on the financial services industry to carry out the legwork of supporting borrowers during the COVID-19 pandemic.

“There are very real concerns with regard to bank health in particular, especially the way they've been used for some of the lending programs. There are going to be some big write-downs associated with some of that, and the money has to come from somewhere,” said Joseph Mason, a professor of finance at Louisiana State University.

“For good or bad, and you have to keep the banks healthy enough play their role," Mason said.

Bank industry watchdogs, and even some policymakers, have characterized the stress test results as a red flag, saying limits on capital distribution through buybacks and dividends don’t go far enough to ensure that banks are strong enough to withstand a prolonged recession.

Watchdog groups also criticized the timing of the Volcker Rule relaxation.

“It's increasingly looking like there will soon be a massive wall of credit defaults, and the Fed is telling banks to take off the seat belts and hit the gas,” said Tyler Gellasch, executive director of the Healthy Markets Association.

“Regulation is tricky because bankers want the benefit of having that backstop of the Fed, but they also want to make money,” Routledge said. “So if they take a lot of risk and win, they take big profits, and if they take big risks and lose, taxpayers wind up bailing them out.”