The U.S. domestic equity markets closed down following another volatile week of trading. Followed by an accelerated increase in new cases of COVID-19, investors sold off their risky assets causing weekly losses for the major indices. The tech-heavy NASDAQ closed down 1.89% for the week with the S&P and Dow Jones Industrial Average posting 2.76% and 3.28% losses respectively. Investors continue to hold their breath as markets wait and watch for concrete economic guidance as to the direction and timeframe of an economic recovery. Yet equity valuation proves trickier and trickier for both retail and institutional investors as industry-leading firms within the consumer discretionary, technology, and heavy machinery sectors have scrapped financial forecasts. Short-term predictions must also take into account further monetary intervention from the Federal Reserve as well as the upcoming presidential election.
The Federal Reserve has recently taken steps to ensure the security and liquidity of the American banking sector amid persistent economic uncertainty. Following liquidity injections in the form of credit facilities and corporate bond-buying, the Fed mandated limits on share buy-backs and shareholder dividends to ensure appropriate capital funding levels for all major banks in the event of further economic distress.
Limits on share buy-backs will prevent major banks from returning funds to shareholders in exchange for their shares of stock - a common transaction for banks to redistribute capital from their balance sheets. Stock buy-backs usually occur as a mutually beneficial financial operation - corporate leaders agree to buy back large quantities of outstanding stock from investors in exchange for cash. As the total quantity of outstanding shares in the market falls, theoretically, share prices rise. Yet cash is returned to shareholders at the opportunity cost of corporate reinvestment in items such as workforce development, expansion, or research and development. Furthermore, critics point to corporate executives encouraging share repurchase programs to increase share prices solely to boost their own stock-based compensation structures.
Banks were warned however, of potential losses stemming from mass defaults on corporate and consumer loans. After near financial catastrophe in 2009 following the mortgage-lending crisis, the Fed has made a point to ensure all domestic banks are adequately capitalized through all potential scenarios. U.S. banks must adhere to strict standards issued by the Board of Governors of the Federal Reserve System. Financial ratios assess a bank’s liquidity and capital structure given their capital ratios - calculations measuring credit risk of both on-balance sheet and off-balance sheet assets and liabilities. The Fed’s recent policies of limiting share repurchases and halting shareholder dividends aim to force banks to retain as much capital as possible in order to be a strong link in the financing chain for all corporations - domestic and international.
Even as companies from Wall Street to Main Street emerge and reopen their doors for American consumers, careful attention must be paid to all parties involved in the financial supply chain. As uncertainty continues to loom large in equity markets, the central bank is taking steps to limit risk from the largest players in the credit market - our banks.