Financial Sector ETFs Feel the Stress Under New Fed Requirements

Bank stocks and sector-related exchange traded funds were dealt a heavy blow after the Federal Reserve conducted its annual stress test and found that large banks need to preserve capital by suspending share repurchases and limit dividend payments.

Among the worst-performing non-leveraged ETFs of Friday, the Invesco KBW Bank ETF (NASDAQ: KBWB) declined 5.82% and SPDR S&P Bank ETF (NYSEArca: KBE) decreased 5.4%. Meanwhile, the broader Financial Select Sector SPDR (NYSEArca: XLF) was 3.9% lower, compared to the 2.0% pullback in the S&P 500.

The Fed said banks can’t raise dividends or resume stock buybacks through at least the third quarter due to the ongoing uncertainty over the COVID-19 pandemic.

Fed Gov. Lael Brainard argued that under the very worst case COVID-19 scenarios, “many” banks would operate within stress capital buffers and a quarter of the banks would be close to minimum capital standards, MarketWatch reports.

“Past experience shows that banks operating close to their regulatory minimums are much less likely to meet the needs of creditworthy borrowers, and the resulting tightening of credit conditions could impair the recovery,” Brainard added.

Given the ongoing economic woes stemming from the coronavirus pandemic, the Fed will be “very hands-on” until the economy stabilizes, so the central bank can “pull the trigger on capital distributions more rapidly if needed,” according to Morgan Stanley’s Betsy Graseck, Bloomberg reports.

Investors may be pricing in further dividend cuts if economic conditions worsen. Cowen’s Jaret Seiberg warned that the Fed has put “the market on notice that dividends could be suspended or restricted more severely starting in the fourth quarter if bank losses grow and the economy gets worse.”

Going forward, the bank sector could suffer from further belt-tightening as many try to cut costs and meet increased capital requirements.

“The Fed’s stress test indicates that this institution has serious questions concerning future bank earnings and capital,” Odeon’s Dick Bove told Bloomberg. “It also indicates that a number of banks must sharply reduce their payouts. Uncertainty and lower yields is not the basis for rallying these stocks.”

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