The US Federal Reserve announced last week that it will extend its current restrictions on dividend payouts and prohibition of stock buybacks for the nation’s largest banks through the end of 2020. The measures first were announced in June as the result of stress tests conducted by the Fed to assess the staying power of banks in the event the virus-related recession worsened. Anxious to pick up some of their own depressed shares at a discount, the banks were hoping to see the strictures removed on October 1.
Stock buybacks or “repurchases” allow a publicly traded company to buy and hold shares of its own stock in the open market. The primary justification stated for the boom in buybacks is the return of capital to shareholders. If a company holds a large cash balance and does not see enough profitable opportunities to invest that cash, firms can repurchase shares with the cash to reduce the outstanding pool (called the “float”) and theoretically increase the value of remaining shares outstanding.
The practice, while widespread (one might say epidemic), has been controversial. Stock buybacks were long considered a form of manipulation and were only legalized by the SEC in 1982. Historically, the average buyback has worked to the detriment of shareholders, as companies too often overpay for the stock they repurchase. Nevertheless, management compensation is typically tied to stock performance, and buybacks can serve as a short-term boost to the share price and therefore CEO pay, hence the dramatic expansion of the practice. Recently, companies have been on a borrowing spree and are using cheap debt to finance repurchases of stock. And while the 2017 Tax Cuts and Jobs Act was ostensibly targeted at stimulating corporate investment, in fact most of the windfall was used to buy back stock and pad management remuneration. Buybacks in 2018 smashed previous records, and while 2019 was down, it still ranked number 2 in history.
Of course, if a company guesses correctly, it can profit from buying up cheap shares to reissue at a later date and higher price. That is in part what the big banks would like to accomplish with the present price of their shares significantly depressed in the wake of covid. Normally, this decision would be made by company management. But as we learned in 2008 (actually re-learned for the umpteenth time), banks are different. A bank’s ability to survive an economic decline is a direct function of the amount of capital it holds as a backstop. When times are flush, banks understandably resist holding excess capital, preferring to lend out the maximum amount possible, and regulators tend to relax standards as memories of past crises fade.
The financial crash of 2008 brought the lesson home again, as several of the world’s largest banks faced potential collapse and required government intervention and taxpayer rescue. Reforms emerging from the crisis included (slightly) more stringent capital requirements and the practice of stress testing banks’ balance sheets against hypothetical scenarios. The latest round of stress tests, conducted by the Fed in June, resulted in the prohibition of stock buybacks for the third quarter; these have now been extended through year end.
The edict affects the 33 financial institutions in the US with more than $100 billion in assets, considered large enough to pose a systemic risk to the financial system in the event of failure. The Fed action also imposes a limit on dividend increases tied to a profitability formula, to enforce the additional capital cushion. Note that the 6 largest US banks collectively have increased their dividends per share 7-fold since the Great Recession.
The Federal Reserve plans another round of stress testing in December, in time to announce possible relaxation of the dividend and repurchase limits for the first quarter of 2021. It is notable that the memory of the financial crisis is recent enough that the reforms and capital requirements are still in place and that despite the severe drop in GDP during the second quarter, the solvency of US banks has not come into question. Good news.
Christopher A. Hopkins, CFA