All of the nation's largest banks passed the Federal Reserve's stress tests, allowing them to return capital to shareholders in the form of dividends and share buybacks.
But shareholders shouldn't bank on bigger dividend checks. The majority of capital returns by the nation's largest banks will come in the form of buybacks rather than dividends.
Banks prefer buybacks for the simple reason that the Federal Reserve is less critical of plans that allocate more capital to share repurchases. A share repurchase plan can be stopped at any time with modest consequences. Dividends, on the other hand, are often seen as a payment that shareholders expect to be paid with regularity.
In an adverse economic climate, reducing a dividend often leads to an immediately lower stock price, making it more difficult for banks to raise capital by selling stock, if stock issuance is deemed necessary to improve their capital position.
The Fed generally allows for large banks to distribute 30% of their earnings as a dividend, whereas higher payout ratios are less likely to get the rubber stamp. In its 2017 instructions for large and complex firms, the Fed wrote the following: "[R]equests that imply common dividend payout ratios above 30 percent of projected after-tax net income available to common shareholders in either the BHC baseline or supervisory baseline will receive particularly close scrutiny."
Paying higher prices
The post-election "Trump Bump" in bank stocks means that buyback plans won't go as far as they would have last year. Bank of America shares are up nearly 94% in the last year. The worst performer in the list above, Wells Fargo, is trading 21% higher than its year-ago price.
Interestingly, Wells Fargo and US Bancorp, the companies with the lowest one-year stock returns, are content sending proportionally more cash out the door in dividends than their big bank rivals. Meanwhile, Bank of America, Citi, and JPMorgan lead the pack in stock performance over the last year, and will spend proportionally more buying back their shares at elevated prices.
Earlier this year at a banking conference, the JPMorgan CEO Jamie Dimon and Bank of America CEO Brian Moynihan indicated that higher dividends may make more sense than buybacks, given elevated stock prices for the nation's largest banks. (Learn more about stress test results for Bank of America and JPMorgan.)
Of course, getting approval to make share repurchases is simply that -- approval. It doesn't mean that banks have to use their new authority to repurchase stock. Instead, a buyback program can lie in wait for opportunistic repurchases at lower valuations.
For this reason, bank investors should watch how the nation's largest banks choose to use their increased authorizations over the next few quarters. The pace of repurchase activity may indicate whether bank's higher share prices are reflective of a brighter future, or overconfidence about higher rates, lower taxes, and fewer regulations during the Trump years.
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