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The Federal Reserve on Thursday temporarily restricted shareholder payouts by the country’s biggest banks, barring them from buying back their own shares or increasing dividend payments in the third quarter as regulators try to ensure banks remain strong enough to keep lending through the pandemic-induced downturn.

The decision to limit payouts is an admission by the Fed that large financial institutions, while far better off than they were in the financial crisis, remain vulnerable to an economic downturn unlike any other in modern history. With coronavirus cases across the United States still surging and business activity subdued, it remains unclear when and how robustly the economy will recover.

Some of the Fed’s own loss projections for banks, in fact, suggest that the eventual hit to loans in a bad scenario could be far worse than in the aftermath of 2008. That outcome helped drive the new restrictions.

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Still, the Fed stopped short of barring banks from paying dividends as some lawmakers and former regulators have urged – a decision that drew public criticism from one of the Fed’s current governors, who said not taking stronger measures could “impair the recovery.”

The Fed, which devised its primary stress test scenarios before the virus tore through the economy, will require the 34 banks subjected to the test to resubmit and update their capital plans later this year. Those plans detail how the banks intend to proceed with share buybacks and dividend increases in light of the pandemic, and the Fed said that resubmitting them “will help firms reassess their capital needs.”

It will also allow the Fed to reserve the right to run additional stress tests or sensitivity analyses, and potentially restrict payouts, further down the road.

“Today’s actions by the board to preserve the high levels of capital in the U.S. banking system are an acknowledgment of both the strength of our largest banks as well as the high degree of uncertainty we face,” Randal Quarles, the Fed’s vice chairman of supervision, said in a statement.

The central bank announced the restrictions alongside the results of its annual stress tests, which assess how the banks would fare under dire scenarios that include high unemployment and severe market turbulence. While those tests are meant to be hypothetical, this year’s scenarios were set before the pandemic, and some of the economic projections made in the Fed’s worst-case recession look relatively benign.

To compensate for that, the Fed ran an additional analysis to gauge how the banks would perform under coronavirus recessions of varying severity. The hypothetical scenarios included a sharp bounce-back, an extended U-shaped downturn and a double-dip W recession.

In aggregate, under those severe analyses, loan losses for the 34 banks ranged from US$560-billion to US$700-billion, and overall capital ratios declined from 12 per cent in the fourth quarter of 2019 to between 9.5 per cent and 7.7 per cent. The Fed did not release results for individual banks as it does with the annual stress tests.

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“Under the U- and W-shaped scenarios, most firms remain well capitalized, but several would approach minimum capital levels,” the Fed said in its release.

The Fed will cap dividends to the amount paid in the second quarter, with an additional limitation based on recent earnings. Officials could have placed restrictions on shareholder payouts earlier in the coronavirus crisis, and the decision to do so now is a sign that regulators believe the financial system could face threats if the downturn drags on.

The money that banks can no longer distribute to shareholders can be used instead to absorb losses and make loans to households and companies. That will help if banks make large losses as borrowers struggle to repay loans over the coming months.

But Lael Brainard, a Fed governor who was nominated and confirmed during the Obama administration, objected to the fact that banks are still allowed to pay out dividends in any fashion.

“The payouts will amount to a depletion of loss-absorbing capital,” she wrote in a statement. “This is inconsistent with the purpose of the stress tests, which is to be forward-looking by preserving resilience, not backward-looking by authorizing payouts based on net income from past quarters that had already been paid out.”

With coronavirus infections rising in some states, consumers may remain skittish, and the job market is expected to remain weak. Unemployment jumped to 14.7 per cent in April before easing to 13.3 per cent in May. In the severely adverse February, 2020, scenario, it topped out at 10 per cent.

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The Fed’s stress tests were introduced after the 2008 financial crisis as a way of making sure regulators had an up-to-date grasp of the risks in the banking system – something they lacked before the housing market crash. The exams focus on how much capital a bank would have left after the different stress scenarios.

Capital is money banks don’t have to pay back to creditors and depositors. The more capital they have, the more losses they can theoretically absorb.

Investors appear to have doubts about how the banks will perform in the recession.

Bank stocks are down by nearly one-third this year, compared with a 5-per-cent decline for the S&P 500 stock index. Unlike in 2008, the banks aren’t the epicentre of the crisis and have actually experienced large inflows of money rather than outflows. Lending to corporations soared in the first quarter as companies drew on their credit lines and trading revenue surged at banks with large Wall Street operations. But their first-quarter earnings took a hit as they added billions of dollars to their loan loss reserves in anticipation of widespread defaults.

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