(Bloomberg Opinion) -- Bank executives naturally want to keep their shareholders happy. So amid what promises to be one of the deepest economic downturns ever, the largest U.S. financial institutions are planning to keep paying dividends — a practice that depletes the loss-absorbing capital they will need to get through the crisis. Just this week, for example, JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said that he intends to keep making payments despite what he expects to be a “bad recession.”
The Federal Reserve has made the mistake of allowing such behavior before. It shouldn’t do so again.
Ample capital matters not only for individual banks. It makes the whole financial system, and hence the economy, more resilient to shocks like the one we are now experiencing. To ensure banks have enough, the Fed conducts annual stress tests in which it subjects them to a hypothetical severe recession. If they don’t pass, it forbids them to make payments to shareholders — in the form of dividends and share buybacks — until they are adequately capitalized.
The Fed announced the scenarios for the latest round of stress tests in February, before the coronavirus became a pandemic. The severely adverse scenario included an increase in the unemployment rate from 3.5% to 10% — a shock that now seems quaint. Justin Wolfers, an economist at the University of Michigan, estimates that the unemployment rate already exceeds 13%. The Federal Reserve Bank of St. Louis predicts that it might eventually rise to more than 30%.
In other words, the recession is sharper and deeper than the Fed could have imagined only two months ago. Banks will suffer surprisingly large losses as millions of Americans miss payments on loans. This will eat into capital, further threatening an already fragile financial system and economy.
Given the dire outlook, banks should be conserving as much capital as possible. That’s what regulators in the U.K. and continental Europe are pushing the institutions they oversee to do. The Fed should follow their lead and ask the largest U.S. financial institutions to make no dividend payments or share repurchases in 2020 and 2021, and to reduce or eliminate bonuses to their officers.
About a decade ago, Eric Rosengren, President of the Federal Reserve Bank of Boston, pointed out that when the U.S. government bailed out the largest financial institutions in 2008, about half the money went to make up for their payouts to shareholders after the crisis had started in 2007. To prevent the same kind of harmful capital depletion from happening again, and to maintain its credibility as a financial supervisor, the Fed must act now.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Narayana Kocherlakota is a Bloomberg Opinion columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
©2020 Bloomberg L.P.