Each year, as a condition of the Dodd-Frank financial reforms that were implemented in the wake of the 2008 financial crisis, banks over a certain asset size must submit to a "stress test," which is designed to determine what would happen to each bank's capital levels during a severe global recession.
Specifically, the banks are required to maintain four capital levels above minimum thresholds:
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- Tier 1 leverage (minimum 4%)
- Common equity Tier 1 ratio (4.5%)
- Tier 1 capital (6%)
- Total capital ratio (8%)
The 2018 stress tests results were announced recently, and all 35 of the banks tested passed. This was widely expected, as the financial industry has improved tremendously over the past decade or so.
The most important part for investors
While passing of the stress test is certainly good news, the more interesting part for investors is the review of certain banks' capital plans. In other words, the big banks need to obtain approval from the Federal Reserve before using some of their capital to buy back shares or pay dividends.
This year, 18 of the largest and most systemically important banks were subject to a capital plan review, and of these, 15 got a clear green light to proceed, including all of the "big four" U.S. banks.
There were a few disappointments. Investment banking giants Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) were both given "conditional non-objections" and are required to maintain last year's capital return levels. State Street's (NYSE: STT) capital plan was conditionally approved, but the bank must take certain steps to manage its exposure to falling capital levels.
And finally, Deutsche Bank USA (NYSE: DB) was the only bank whose capital plan was rejected and is required to be resubmitted, due to "material weaknesses in the firm's data capabilities and controls supporting its capital planning process, as well as weaknesses in its approaches and assumptions used to forecast revenues and losses under stress."
Which big banks announced dividend and buyback increases?
After the results of the capital plan reviews were announced, most banks individually announced increases (or maintenance) of their stock buybacks and dividends for the next year. Here are a few of the most significant:
- <strong>Bank of America</strong> (NYSE: BAC) will give shareholders a 25% dividend increase to an annualized rate of $0.60 per share and will also increase its buyback authorization to $20.6 billion over the next year, up from the <a href="https://www.fool.com/investing/2017/12/06/bank-of-america-is-buying-back-even-more-stock-her.aspx?&utm_campaign=article&utm_medium=feed&referring_guid=9910dde5-4d91-4aa5-9139-f06279dae2b1&utm_source=foxbusiness" target="_blank">previous year's</a> $12.9 billion.
- <strong>Citigroup</strong> (NYSE: C) is giving shareholders an impressive 41% dividend hike to a quarterly payout of $0.45 per share and is also planning to spend up to $17.6 billion on buybacks over the year, a modest but significant $2 billion increase over the previous plan.
- <strong>Wells Fargo</strong> (NYSE: WFC) was one of the big positive surprises, after a <a href="https://www.fool.com/investing/2018/06/15/is-wells-fargo-company-a-buy.aspx?&utm_campaign=article&utm_medium=feed&referring_guid=9910dde5-4d91-4aa5-9139-f06279dae2b1&utm_source=foxbusiness" target="_blank">tough couple of years</a> for the bank. Wells announced that its dividend will increase to $0.43 per share in the third quarter, and that it plans to spend as much as $24.5 billion on buybacks over the next year -- a sharp increase from the past year's $11.5 billion.
- <strong>JPMorgan Chase</strong> (NYSE: JPM) is raising its dividend by 43% to $0.80 per quarter, and is planning to buy back as much as $20.7 billion in shares over the next year, a mild increase from its 2017 capital plan, which called for $19.4 billion in buybacks.
- <strong>U.S. Bancorp</strong> (NYSE: USB) plans to increase its dividend by 23% to a quarterly payout of $0.37 and to repurchase as much as $3 billion of its stock over the next year, up from the previous authorization of $2.6 billion.
- <strong>American Express</strong>' (NYSE: AXP) capital plan was closely watched, since the bank had decided to suspend buybacks for the first half of 2018 in order to bolster capital levels. The bank announced that it would repurchase up to $3.4 billion in shares over the next year and also plans to raise its quarterly dividend from $0.35 to $0.39 per share.
And as I mentioned earlier, Goldman Sachs and Morgan Stanley were both instructed to leave their previous capital distribution amounts unchanged. Both are planning small dividend increases, but the overall amount of money they're planning to return to shareholders is approximately the same as over the past year.
Why the big emphasis on buybacks?
One important thing to notice is that most banks are placing far more emphasis on buybacks than dividends. For example, even with a significant dividend raise, Citigroup's buyback makes up 80% of its capital plan. Other banks are similarly buyback-oriented.
There are a couple of potential reasons for this. For one thing, it indicates that these banks' managers still believe their shares are a compelling long-term value. And second, it's far easier to maintain a modest dividend in the future than an aggressive one. Cutting a dividend can be devastating to a stock, while a buyback reduction is typically more painless to implement.
In any case, most big-bank shareholders should expect to see a raise in the coming months, but should also expect to see outstanding share totals fall significantly, which could result in a sharper-than-expected increase in earnings per share.
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