Is the COVID-19 financial shock a good measure of bank strength?

In the wake of the economic meltdown triggered by the COVID-19 pandemic, a narrative has emerged about the financial strength of the nation’s largest, most systemically important banks. Some policymakers and banking industry advocates suggest the banks were not only strong enough to survive the crisis, but that their financial strength helped lead the subsequent recovery.

A new analysis by Minneapolis Fed First Vice President Ron Feldman and Senior Financial Economist Jason Schmidt shows the truth is more complicated. They find that government action—such as the unprecedented fiscal stimulus, the Paycheck Protection Program, and restrictions on stock buybacks and dividends—helped shield large banks from serious consequences of the COVID-19 financial shock.

A balanced assessment of bank performance during the COVID-19 crisis is important, they write, “because the story we tell about banks’ financial strength in 2020 has implications for important policy choices leaders will make going forward,” particularly with respect to bank equity requirements, which serve to prevent bank failures and the need for taxpayer-funded bailouts.

Government action bolstered bank balance sheets

It is true that banks did not receive a direct bailout from the federal government, as in 2008. However, the unprecedented fiscal stimulus provided substantial indirect assistance by helping millions of Americans avoid defaults on mortgages and business loans that could have sent the financial industry into a tailspin.

Feldman and Schmidt calculate that government action could have prevented $230 billion in loan losses over the final three quarters of 2020. They estimate a further benefit of up to $95 billion from bank profits that would have evaporated without Federal Reserve actions to prevent a full-blown global market shock. This total COVID-19 crisis benefit to banks adds up to $325 billion. By comparison, the Troubled Asset Relief Program (TARP) following the 2008 financial crisis ultimately expended $460 million.

They argue further that Federal Reserve actions—not bank decisions—deserve credit for the 8 percent increase in capital levels at large banks during the COVID-19 crisis. “This increase in capital was not the result of banks raising additional equity from investors,” they write. “Instead, capital levels rose because the Federal Reserve prevented these large banks from spending billions of dollars buying back their own stock.” They point out that banks repurchased $77 billion of their own stock in the second half of 2019, while repurchasing less than 1 percent of that amount in the second half of 2020.

Government, not banks, boosted lending (and only to businesses)

Bank lending in the first months of the pandemic grew at the fastest rate in more than 40 years, and business lending accelerated again in the second quarter. Rather than banks stepping up to the plate, however, Feldman and Schmidt see two separate trends that cast this lending in a more passive light.

Outstanding commercial and industrial loans by banks surged almost 16 percent in the first quarter of 2020. But this appears mostly the result of firms drawing on existing lines of credit, as an immediate-term mechanism to cope with the pandemic shock. Taking this into account, the authors find aggregate commercial and industrial credit only rose by an underwhelming 1.6 percent. While it is a good thing that many businesses had credit capacity to draw down in a crisis, they write, “it is not clear this development is a source of strength” for the banks.

Bank loans rapidly increased again in the second quarter of 2020. By this point, however, banks were administering billions of dollars in government-guaranteed, forgivable loans under the Paycheck Protection Program (PPP). Banks faced little, if any, risk while collecting $19 billion in fees for distributing the funds. Removing PPP loans from the calculation, Feldman and Schmidt find that banks’ lending portfolios would be no larger than before the pandemic.

Stress test assumptions underplay the risks

The Federal Reserve performs periodic “stress tests” to assess the resiliency of banks to a range of hypothetical pressures and crisis scenarios, including whether they retain enough capital to meet withdrawal and other needs. Advocates for the banking industry see a strong argument in the COVID-era results. “All major banks passed those stress tests with room to spare,” wrote the Bank Policy Institute. “One would have to work pretty hard to see this episode as anything other than a vivid demonstration that post-crisis reforms have left banks with more than ample capital and liquidity.”

Feldman and Schmidt counter that the Fed’s own stress tests performed in 2020 did not reflect the true depth of the COVID-19 financial crisis. They note that the tests conducted in mid-2020 included bank positions from the end of 2019, before the beginning of the pandemic. The tests released at the end of 2020 were based on data from the end of June, after conditions had already begun to stabilize thanks to government efforts. Moreover, results from the harshest scenario used in the 2020 tests (the “W-shaped” recession from the sensitivity analyses) revealed that 8 of the 33 banks were projected to have capital ratios fall below 4.8 percent. Under the old rules of the stress tests, many of these firms would likely have failed the exercise since their capital ratios were likely under 4.5 percent. Celebrating the passage of 2020 stress tests, they write, “ignores the many ways in which these tests were weakened.”

The Minneapolis Fed’s own stress test tool provides an alternate perspective on how the 21 largest banks hold up under various hypothetical scenarios.

COVID-19 shows stronger capital requirements needed

Feldman and Schmidt caution policymakers and bank regulators against drawing conclusions about the efficacy of the current regulatory and supervisory system based on the performance of large banks in 2020.

“We do not see the case, based on banks’ performance during the early stages of COVID-19, for relaxing bank regulation or supervision,” they write. “Instead, we should strive for a robust regime that further reduces the likelihood taxpayers will need to bail out the largest banks.”