Preferred Stocks: Will Fed Bank Stress Tests Lead to Suspended Dividends?

Are preferred stock dividends at risk of being suspended?

We believe the risk that preferred-stock dividends will be suspended is low despite the recent announcement by the Federal Reserve that it is requiring banks to cap their common stock dividends. With the results of its 2020 Dodd-Frank Act Stress Test, the Fed issued rules on what banks can or can’t do with their income and how much can be used for shareholder-friendly activities, capping the amount that can be paid out as common-stock dividends. However, preferred-stock dividends were not included in those rules. We can’t rule out the risk of dividend suspensions longer term if the economic outlook deteriorates, but our current view is that the risk of industry-wide dividend suspension is low.

The good news

All 33 banks that the Fed tested performed well, and the executive summary stated that banks have generally been a source of strength through the crisis. As of now, all large banks are deemed to be sufficiently capitalized. Because banks and other financial institutions are generally the largest issuers of preferred stocks, the Fed’s stress tests are important when evaluating the ability of preferred issuers to make timely income payments.

The scenarios in the stress test were prepared well in advance, and even the most severely adverse scenario wasn’t as big a shock as recently experienced. In the severely adverse scenario, the Fed projected a rise in the unemployment rate to 10% by the third quarter of 2021. That severe shock became dated when the unemployment rate rose to 14.7% in April, before dropping to 13.3% in May.

As a result, the Fed also conducted a sensitivity analysis, given the economic impact of COVID-19. In addition to the scheduled stress test, the Fed constructed three alternative downside scenarios and subsequent recovery outlooks:

  • A rapid V-shaped recovery that regains much of the output and employment lost by the end of this year;
  • A slower, more U-shaped recovery in which only a small share of lost output and employment is regained in 2020;
  • A W-shaped double-dip recession with a short-lived recovery followed by a severe drop in activity later this year due to a second COVID event.1

Even under the more somber outlooks of the “U” and “W” shaped recoveries, the “large majority of the banks remain sufficiently capitalized over the entirety of the projection horizon in all scenarios,” according to the Fed.2

As the chart below illustrates, even under the worst scenarios, the aggregate minimum common equity tier 1 ratio is above the Fed’s base minimum of 4.5% as well as the aggregate low from 2008. Note that the “2008 low” referenced in the chart below represents the low for all financial institutions, not just the largest ones as represented in the 2020 Dodd-Frank stress tests.

Capital ratios are projected to be above 2008 levels even under the most negative scenarios

Source: Federal Reserve, “Assessment of Bank Capital during the Recent Coronavirus Event,” June 2020 (blue columns), and New York Federal Reserve, “Quarterly Trends for Consolidated U.S. Banking Organizations, First Quarter 2020” (yellow line). The Common Equity Tier 1 Ratio is calculated as common equity tier 1 capital divided by risk-weighted assets.