For big banks, it was a good news/bad news kind of week.
Despite receiving some good news on the regulatory front this week, Wall Street’s big banks also got a dose of reality in the form of the Federal Reserve’s stress tests.
On one hand, federal regulators finalized their loosening of certain provisions of the Volcker Rule—the Great Recession–era regulation, adopted as part of the Dodd-Frank Act, that prohibited banks from making certain investments deemed overly risky.
The eased restrictions mean that banks can now invest more freely in private equity funds, hedge funds, and venture capital funds—investments dubbed “speculative” that were restricted by Dodd-Frank’s passage in 2010. Additionally, banks are no longer required to set aside cash when making certain derivatives trades.
The revisions may alter rules designed to prevent a replay of the worst financial crisis since the Great Depression, but they will also likely free up billions of dollars of capital on banks’ balance sheets. As expected, investors took kindly to the news, and bank stocks shot up on Thursday afternoon—at least until the Fed spoiled the party.
Later in the day, the central bank released the results of its 2020 stress tests, meant to evaluate how the country’s largest financial institutions would cope with adverse economic conditions. While the tests—which were made more stringent in the wake of the coronavirus pandemic—found that the banks would be able to withstand “even the harshest shocks” to the financial system, they still revealed enough stress for the Fed to step in with some proactive, restrictive measures.
Large banks are now prohibited from pursuing share buybacks in the third quarter of this year. They’re also being forced to cap upcoming shareholder dividend payments “to the amount paid in the second quarter,” and must limit them to “an amount based on recent earnings.” In short, a bank “cannot increase its dividend and can pay dividends if has earned sufficient income” in the third quarter, per the Fed.
It was enough to send bank stocks down in after-hours trading Thursday—a drop that extended into Friday, which was a bad day for the market at large (the Dow was down nearly 3%) but particularly for financial stocks. While the S&P 500 fell 2.4% on the day, the S&P’s financials sector was down 4.3% Friday—the second-sharpest drop of all 11 industry sectors tracked by the index.
Wall Street’s bearish reaction shouldn’t come as a surprise. As the Fed noted, buybacks have represented roughly 70% of shareholder payouts from large banks in recent years, and the central bank’s restrictions will hit investors where it hurts. Wells Fargo and Goldman Sachs, in particular, may be forced to cut their dividends next quarter, analysts at investment bank KBW wrote in a note, while Morgan Stanley analysts pegged Capital One (as well as Wells Fargo) as a potential casualty.
Despite the stock market’s extraordinary rebound since March’s coronavirus-induced correction, it appears that Wall Street is not wholly immune to the economic downturn that has devastated much of the U.S. economy. And just as regulators gave the big banks a gift in the form of a relaxed Volcker Rule, the Fed’s new restrictions show how easily regulators can rain on their parade.