The writer, president and chief executive of the Federal Reserve Bank of Minneapolis, oversaw the Troubled Asset Relief Program in 2008-09
Large banks are eager to be part of the solution to the coronavirus crisis. The most patriotic thing they could do today would be to stop paying dividends and raise equity capital, to ensure that they can endure a deep economic downturn. Unlike the rest of us, banks have the ability to essentially vaccinate themselves against this crisis. They should do so now.
When financial strains emerged in 2007, US officials urged large bank chief executives to raise equity to make sure they had the wherewithal to survive a crisis. The most common answer was: “We’re fine. We don’t need it. Our balance sheet is rock solid.” They only realised that they had serious problems after the deep losses were obvious to everyone, especially financial markets. At that point it was much more difficult, if not impossible, for them to issue equity because their stock prices had already collapsed. And that was when governments in the US and elsewhere had no choice but to step in with bailouts.
Here is how a prolonged Covid-19 crisis could put banks at risk again. We have already heard stories about how US small businesses, having laid off their staffs, tell their landlords they will not pay rent until the crisis passes. The landlords then tell their bankers they will not make the mortgage payment. Multiply that example by thousands. The economic costs of the crisis eventually roll up into the banking sector.
Banks have to pay the interest on their own liabilities, such as deposits. Doing otherwise would trigger a default. So they must pay their creditors while absorbing the losses out of their equity. While banks have more equity today than they had going into the 2008 financial crisis, the lockdowns are imposing economic hardship far more quickly this time.
We simply do not know how large the losses from this crisis will be, because the depth and duration of the downturn depends on how the virus progresses and how our healthcare systems respond. Experts say a vaccine will not be ready for 18 months. Will new therapies emerge sooner that allow us to relax the economic shutdown while still protecting people? Nobody knows.
It is not hard to see scenarios where we have to impose some economic controls for months on end. In 2009, according to the Centers for Disease Control and Prevention, 61m Americans, or roughly 20 per cent of the population, contracted swine flu. Fortunately the mortality rate was low. There is still tremendous uncertainty around the Covid-19 death rate.
Even if government officials relax official controls, should the virus continue to spread rapidly Americans will socially distance on their own. Most people are not going to expose their families to serious health risks if they can avoid it.
An extended economic downturn could easily sap banks’ current equity capital. Stress test modelling by the Minneapolis Fed indicates that under severe Covid-19 scenarios, large banks, those with assets greater than $100bn each, could together lose hundreds of billions of dollars of equity capital.
Banks will argue that this crisis is not their fault, any more than it is the fault of airlines or hotel operators. So why should they not get a bailout too? There is an important difference: we can see this risk coming and banks have time to prepare for it. Airlines and hotel companies did not have advance warning.
Everyone else is doing extraordinary things. People are staying home and sacrificing their livelihoods to slow the virus. First responders are working night and day to care for the sick, while potentially exposing themselves. Congress just passed a $2tn rescue package. The Federal Reserve has launched numerous emergency lending programmes. Banks must do their part by discontinuing dividends and raising capital now.
In 2008, US taxpayers injected about $200bn of capital to strengthen banks. Raising that amount from private investors today, as a strong, preventive measure, would ensure that large banks can support the economy over a broad range of virus scenarios.
If the crisis turns out less serious than we fear, banks can return the capital through buybacks and dividends once the crisis passes. We will then celebrate their action to support the public during a national emergency. As bankers are fond of telling their clients: no one has ever regretted raising capital.
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