Key Investor Takeaways From the 2018 Bank Stress Tests

Investors didn't get too many surprises from this year's Federal Reserve bank stress tests, but that doesn't mean that there isn't anything worth noticing.

In this clip of Industry Focus: Financials, host Shannon Jones and contributor Matt Frankel discuss how investors should interpret the results and one big trend with capital returns that is important to know.

A full transcript follows the video.

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This video was recorded on July 2, 2018.

Shannon Jones: For most investors that are listening or curious, in terms of, what are the takeaways? Should I be concerned with Goldman Sachs and Morgan Stanley not being able to do more with dividends and buybacks -- what do you say to that, Matt?

Matt Frankel: In those two cases, not really. Like I mentioned, those were consequences of tax reform and not really anything having to do with the banks' businesses themselves. Both investment banks are doing well. This is a bad effect from tax reform that is ultimately going to have a very good effect on both banks.

As far as the other banks, well, Deutsche Bank is considered a pretty troubled bank by just about anybody you ask. If you weren't worried about it, now, this really shouldn't add anything to the fire. This really wasn't a big surprise.

For the other big banks, this is really just good news. Investors should be very happy. They're getting raises, the banks are buying back more stock, which will make their shares inherently more valuable, before the dividend increases. It's very good news all around.

The other one I forgot to mention was State Street Financial, which also got conditionally approved. Their capital plan was approved as is, they just have to go back and make a few tweaks to some of their processes. That stock, as well, investors shouldn't be terribly concerned.

I would really say this was not a year of very big surprises when it comes to the stress tests. Everyone who we thought would get approved for a big dividend increase did. Some people thought Goldman especially would get approved for a little bit of a capital increase, and they didn't, but I wouldn't read too much into that. Like I said, that's tax reform. Goldman and Morgan Stanley both have a lot going for them.

It's just all around, generally good news. You can tell by the banks' moves shortly after the announcement of the results how good news it was. Wells Fargo had a big pop, for example. But even Goldman Sachs and Morgan Stanley in the market didn't react negatively to it, and for good reason.

Jones: Absolutely. I think one of the bigger trends to watch moving forward will really be on buybacks. Tell us a little more about why buybacks will be a big trend to watch for investors.

Frankel: Since the financial crisis, buybacks have been the priority of banks. There's a couple of things worth noting here. One, buybacks generally convey to investors that management thinks that their stock is on sale. I mentioned this a little bit with Wells Fargo. They've been a massive underperformer in the financial sector since all of their issues started happening. This is management's way of saying, "Our stock is really cheap right now, we need to buy more of it."

This made a whole lot more sense to most investors before, say, two years ago, when banks were still trading at fire sale valuations in the aftermath of the crisis. Now, banks have been the hottest-performing sector over the past few years. It's interesting that management's still emphasizing buybacks. It tells that they still think their shares are compelling value with all the positive catalysts -- tax reform, rising interest rates, a generally healthy economy. That's one thing to note.

The other thing is -- Bank of America CEO, Brian Moynihan, pointed this out -- that a dividend is a much more flexible way to return capital, which is why they have chosen to prioritize them. I'd be pretty confident in saying that a lot of other banks are doing the same. In other words, if the bank runs into trouble, it's a lot easier, from a public perception point of view, to cut a buyback than it is to cut a dividend. A dividend cut makes headlines in the news the next day, it's a big sign of trouble. A lot of the stuff we write for The Fool is, "Oh, there's a dividend cut coming for X company."

A dividend is a very visible way of returning capital to shareholders. A lot of the banks are trying to be very conservative with their dividends -- in other words, keep them at a level that they can maintain even if things go poorly. Whereas, if Wells Fargo reduced its buyback from $26 billion to $25 billion, it really wouldn't be that much of a headline news as a dividend cut would be.

In other words, it's easier to cut a buyback than it is to cut a dividend. That's one reason banks are putting as much money as they're allowed to in buybacks, knowing that if they have to step that back in coming years, then it's not as big of a deal as if they are required to reduce their dividend.

Jones: Great points all around there, Matt. Really, in summary, with these stress tests, banks are much better off than they were previously, and most investors can expect to see capital returned to them. Good times all around.

Matthew Frankel owns shares of Bank of America. Shannon Jones has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.