The Federal Reserve will soon issue guidance allowing some banks to increase dividend payments, Fed Governor Daniel Tarullo said on Friday, but he warned they would have to meet strict standards.
Banks would have to submit plans "that demonstrate their ability to absorb losses over the next two years under an adverse economic scenario that we will specify, and still remain amply capitalized," Tarullo said in a speech at the George Washington University law school.
Tarullo also used his speech to advocate that banks pursue mortgage modifications rather than foreclosures, arguing in most cases it would be a better outcome for all involved.
On dividends, he said banks also will have to show they can meet the new capital requirements laid out in the recent Basel III international agreement and they can "accommodate any business model changes" required by the new financial reform law.
"We also expect that firms will have a sound estimate of any significant risks that may not be captured by the stress testing, such as potential mortgage putback exposures, and the capacity to absorb any consequent losses," he said.
Tarullo said the dividends guidance would go into effect the first quarter of next year.
Banks have been pushing to boost dividends. But regulators have balked at giving them the green light, citing uncertainty about the economic outlook and new capital rules.
With global capital rules and the U.S. financial regulatory system retooling, Tarullo said it is now easier for the Fed to measure whether strong banks should be allowed to increase dividends.
Tarullo waded into the controversy over mortgage foreclosure practices and said overall banks have not done enough to pursue loan modifications for borrowers having trouble making payments.
"It just cannot be the case that foreclosure is preferable to modification — including reductions of principal — for a significant proportion of mortgages where the deadweight costs of foreclosure, including a distressed sale discount, are so high," he said.
State and federal officials, including the Fed, are investigating allegations that for years banks have not reviewed foreclosure documents properly or have submitted false statements to evict delinquent borrowers.
Tarullo did not provide any details about what the review has uncovered but said he hoped it would help spur loan modifications.
He bemoaned the current situation where banks are not pursuing modifications and borrowers stop making payments and stay in their home, sometimes, for more than a year.
"This simply is not a good outcome from any broad perspective — not for the revival of housing markets, not for the banks and investors that hold the delinquent mortgages, and in the longer run, not even for the homeowners themselves, who will ultimately have to move out," he said.
Tarullo also emphasized the importance of the Basel III agreement and said most U.S. banks should be able to easily meet its requirements before the deadlines.
The Basel rules, which have to be implemented by each country, will force banks to hold top-quality capital equal to 7 percent of risk-bearing assets, more than triple current standards, to better withstand economic downturns and financial shocks.
Banks will have until 2015 to meet the minimum core Tier 1 capital requirement, which consists of shares and retained earnings worth at least 4.5 percent of assets. An additional 2.5 percent "capital conservation buffer" will have to be in place by 2019.
Basel negotiators also have said large banks that are important to the smooth functioning of global financial markets should have to meet additional capital requirements. So far, however, no specific agreement has been struck on how to put this idea into practice.
"We think it serves U.S. interests to develop our plans for implementing our domestic statutory obligation in tandem with our participation in this international process," Tarullo said. "Work on this issue in the Basel Committee and the Financial Stability Board will continue well into next year."
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