The banking industry seems to be firing on all cylinders lately. Rising interest rates are translating into better profit margins, tax reform is allowing banks to keep more of their income, and the strong U.S. economy is keeping demand for banking products high and defaults low.
So it may come as a surprise that the Federal Reserve isn't allowing investment banking giants Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) to increase their capital returns to shareholders for 2018, especially since most other big banks are making big dividend raises and buying back billions of dollars in shares. Before you start to get concerned, however, here's an overview of why it's happening and why investors shouldn't be worried.
Goldman Sachs and Morgan Stanley won't be increasing their capital return this year
When Goldman Sachs and Morgan Stanley decided how much in dividends they wanted to pay and how much they'd like to spend on buybacks over the next year, it pushed their capital levels a little too low.
So the banks submitted reduced capital plans to the Federal Reserve as part of this year's stress tests, both of which essentially leave the total capital return unchanged.
Goldman Sachs' plan calls for a return of up to $6.3 billion for the year, and while the plan calls for a $0.05 quarterly dividend increase, it wouldn't go into effect until the second quarter of 2019. Morgan Stanley plans to return $6.8 billion to shareholders over the next year but plans an immediate $0.05 quarterly dividend increase (in the third quarter of 2018) to $0.30 per share.
Both capital plans are in line with last year's, in terms of the overall dollar amounts that can be returned. Since there's a dividend increase in both plans, this implies that slightly lower buybacks will take place.
It's not about the businesses
In previous years, when banks were not permitted to increase their capital returns, it has generally been because of something wrong with the bank's capital levels.
While regulators did indeed determine that Goldman Sachs and Morgan Stanley's capital levels -- specifically, the Tier 1 leverage and supplementary leverage ratios -- would fall below minimum requirements in the event of a severe global downturn, it isn't necessarily because of any wrongdoing, excessive risk-taking, or other mismanagement by the two banks. In fact, both banks are doing quite well.
Instead, Goldman and Morgan Stanley's issue has to do with tax reform. In Goldman's case, the "deemed repatriation" of foreign earnings mostly caused a $5 billion hit, and Morgan Stanley took a "loss" of $1.4 billion due to decreased value of its deferred tax assets on its balance sheet.
What does this mean to investors?
To be clear, this is certainly a disappointment to investors. With tax reform, rising interest rates, and the strong U.S. economy pushing bank profits higher and higher, it's fair to say that many investors were hoping for higher dividends and more buybacks.
Having said that, this is a temporary issue caused by a factor that will ultimately turn out to be a good thing for both banks: tax reform. So while it may take a little longer than shareholders may have hoped to get a raise in the dividend or to see higher buybacks, there's no reason not to believe that both of these banks have bright futures ahead.
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