(Bloomberg Opinion) -- During the next couple of weeks, the Federal Reserve will generate a data point of great interest to investors: After subjecting the nation's biggest banks to so-called stress tests, it will decide how much money they can pay out to their shareholders.
Fed officials should keep in mind that if the number gets much bigger, it could start chipping away at the financial system's foundations.
The annual tests have two stages. First, the Fed examines whether the banks have enough equity capital to survive a hypothetical crisis. It then assesses banks' plans for that capital, and decides how much they can return to investors in the form of dividends and stock buybacks. In determining how tough to be, it has to strike a difficult balance: It wants to keep investors happy, but it must also ensure that banks don’t unduly deplete the equity they need to absorb losses and keep lending when trouble strikes.
The Fed doesn't have a great track record of getting the balance right. Consider what happened ahead of the last crisis: Banks' payouts peaked at 99 percent of their normalized earnings in the second quarter of 2006, precisely when the subprime-mortgage boom was at its peak and they should have been building capital to prepare for the subsequent bust. Even in 2008, when a full-blown crisis was already underway, the Fed allowed the four largest U.S. banks to pay out more than $28 billion. Within months, the government had to come to their rescue.
Now payouts are again on the rise. After last year's stress tests, the Fed allowed banks to boost dividends and buybacks sharply. In the 12 months through March, the four largest U.S. banks gave back about $81 billion -- fully 98 percent of their normalized earnings, up from 10 percent in 2010. Here's how that looks:
If the payout ratio increases any further, it will start eating away at capital. That's a problem, because banks need more. As of the end of 2017, the largest U.S. banks had about $7 in loss-absorbing equity for each $100 in assets (according to international accounting standards). Economists at the Minneapolis Fed estimate that they would require more than twice that amount to make bailouts adequately unlikely.
Will the Fed yet again get the balance wrong? Like it or not, we're bound to find out.
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