The Federal Reserve’s bank stress tests put dividend payments at risk

The Federal Reserve’s bank stress tests put dividend payments at risk

On Thursday afternoon, the Federal Reserve announced the results of its annual stress tests for 33 large U.S. banks and U.S. subsidiaries of foreign banks. Since the Fed’s “severely adverse scenario” for the stress tests was designed in February, before the coronavirus pandemic caused a recession, the regulator also conducted “sensitivity analyses” to reflect a harsher economic reality.

As you can see in the table below, Wells Fargo & Co. WFC, +4.78% appears at greatest risk for a dividend cut among the “big six” U.S. banks.

The Fed announced steps to make sure the banks’ maintained their capital strength, but one member of the Federal Reserve Board said publicly that the measures weren’t strong enough.



Under the severely adverse economic scenario used in the stress tests, the U.S. unemployment rate would peak at 10% in the third quarter of 2021. Since the U.S. unemployment rate had already climbed to 14.7% in April (improving to 13.3% in May), it was obvious that the COVID-19 outbreak had to be considered.

The sensitivity analysis included three different economic recovery scenarios, with unemployment peaking at levels ranging from 15.6% to 19.5%. The good news, according to Federal Reserve Vice Chair for Supervision Randal Quarles, was that “the banking system remains well capitalized under even the harshest of these downside scenarios — which are very harsh indeed.” He also said the banks will be required to “resubmit and update their capital plans later this year to reflect current stresses.”

Here’s the entire statement from Quarles.

Shoring up capital — then backing off a bit

The largest U.S. banks had already suspended their stock buyback programs, but the Fed said these suspensions were now required for the stress-tested banks. Quarles also said ”banks will be prohibited from increasing their dividends and will be further limited in their dividend payments based on recent income.

In its summary of the coronavirus sensitivity analyses, the Fed said third-quarter dividend payments could “not exceed an amount equal to the average of the firm’s net income for the four preceding calendar quarters.” That’s a lot less strict than looking only at the first and second quarters of 2020, which have been greatly affected by the COVID-19 outbreak and incredible rise in unemployment.

The banks’ first-quarter earnings were down because of higher provisions for loan loss reserves, in anticipation of loans souring during the coronavirus recession. At the same time, the “big six” U.S. banks have been seeing a bump in trading and underwriting revenue, so there are many moving parts. Using consensus estimates for second-quarter earnings from FactSet and reported cash dividends paid on common and preferred stock, here’s a comparison of four-quarter estimated earnings averages and first-quarter dividends paid:

Bank holding companyTickerEstimated average net income – four quarters through June ($mil)Cash dividends on Common and preferred shares – first quarter ($mil)
J.P. Morgan Chase & Co.JPM, +3.48%$5,968$3,188
Bank of America CorpBAC, +3.82%$4,999$2,083
Citigroup Inc.C, +3.68%$3,372$1,365
Wells Fargo & Co.WFC, +4.78%$2,207$2,312
Goldman Sachs Group Inc.GS, +4.58%$1,557$538
Morgan StanleyMS, +3.91%$1,909$688
Sources: FactSet, company filings

Only Wells Fargo paid cash dividends during the first quarter exceeding its estimated four-quarter average net income through the second quarter. There are many unknowns, of course. Second-quarter provisions for loan losses may come in lower than expected, for example.

But from the above numbers, it would appear third-quarter dividends are likely to be unchanged from the second quarter, except possibly for Wells Fargo.

In a report published Friday, Jefferies equity analyst Ken Usdin wrote that Wells Fargo “remains the bank that appears closest to the line in terms of having the greatest risk of cutting its dividend (to some extent).”

Oppenheimer managing director Chris Kotowski wrote in a Friday note that for the banking industry, dividend payments will be a “quarter-by-quarter decision,” except for Wells Fargo, “where there is clear risk to the dividend from idiosyncratic issues.” Wells Fargo continues to operate under a consent order with the Fed, under which the bank must continue to improve its corporate governance and limit its asset growth.

The banks will make their capital-plan announcements on Monday, June 29.

Fed governor Brainard says suspend all dividend payments

Lael Brainard, a member of the Fed’s Board of Governors, said in a statement that the banks’ strong capital buffers were allowing them to “play a constructive role in responding to the COVID-19 pandemic.” But she is against giving a “green light for large banks to deplete capital” and believes it is time to suspend dividend payments entirely.

Earnings increase capital and earnings are reduced as loan losses increase. Share buybacks and dividends lower capital. The stress-tested banks are required to suspend buybacks. But according to Brainard, allowing dividend payments now “raises the risk” that banks “will need to tighten credit or rebuild capital during the recovery.”

“Rebuilding capital,” if it were necessary, would probably mean banks would dilute the ownership stakes of current shareholders by selling more shares to the public.

“Temporarily halting shareholder payouts at large banks due to the COVID-19 shock would create a level playing field and allow all banks to preserve capital without suffering a competitive disadvantage relative to their peers,” Brainard said.


Originally published on MarketWatch

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