While the Federal Reserve did not suspend dividend payments as several top economists advocated, a handful of banks are in danger of having to cut their dividends.
The regulator on June 25 prohibited share repurchases and placed a cap on dividends based on a bank's earnings history as part of the Fed's annual stress testing and capital-planning exercise. Based on the formula that dictates how much banks can pay out in dividends, several equity analysts raised the possibility of dividend cuts for Wells Fargo & Co., Goldman Sachs Group Inc., Capital One Financial Corp. and Citizens Financial Group Inc.
"Just based on the Fed's math, it's hard to see how Wells can continue to pay their dividend given market expectations for net income the next few quarters," Brian Kleinhanzl, an analyst for Keefe Bruyette & Woods, said in an interview.
Several other analysts also tabbed Wells Fargo as the bank that will have the toughest time maintaining its dividend. David Rochester at Compass Point Research & Trading wrote that the bank needs to report net income of $1.7 billion in the second quarter to avoid a dividend cut, $1 billion higher than Compass Point's estimate and the FactSet consensus, Rochester wrote.
Analysts noted Goldman as a top contender for a dividend cut by the fourth quarter. The bank's common equity Tier 1 ratio in the first quarter was below its estimated stress capital buffer, a new capital ratio calculated using four quarters of dividend payments plus the estimated stress test losses. Based on the June 25 results, Goldman will need to meet a CET1 ratio equal to 13.7%, but the company's first-quarter CET1 ratio was 12.5% under the standardized approach, Kleinhanzl wrote in a note.
While Goldman's third-quarter dividend is likely safe, based on the Fed's formula, since the stress capital buffer becomes effective Oct. 1, the fourth-quarter payout is in question. Kleinhanzl said the company's first-quarter ratio was lowered by significant balance sheet growth, which should begin to reverse in the second quarter as market volatility declined. The company would need to continue reducing its risk-weighted assets into the fourth quarter to maintain its current dividend, he said.
Other analysts highlighted Capital One as a potential candidate for a dividend cut. Christopher Marinac at Janney Montgomery Scott noted that the company's dividend payments currently exceed earnings from the prior four quarters, similar to Wells Fargo's set-up. Capital One's stress test results also suggest a high-stress capital buffer. Under the stress test, Capital One's CET1 would fall from 12.2% to a low of 6.8%. Analysts at Jefferies estimated that the results suggest the stress capital buffer will push the bank's minimum CET1 over 10%.
"While [Capital One] was expected to have a higher ratio, the magnitude of its burn was decently higher than last year," analysts at Jefferies wrote.
Several regional banks might also struggle to pay their dividends, with Citizens Financial tabbed by several analysts as an example. Compass Point's Rochester said the bank, along with Wells Fargo, is most at risk of a dividend cut by the fourth quarter. KBW's Brian Klock similarly said the bank is at "elevated risk" of a dividend cut by the fourth quarter when using consensus estimates. Klock also highlighted Huntington Bancshares Inc. and KeyCorp as being at risk based on consensus, but he also wrote that all of the regional banks should be able to maintain dividends when using KBW's estimates. He noted that other analysts envision larger provision builds than KBW foresees.
Indeed, the Fed's formula will force banks to weigh loan loss provisioning against a desire to maintain their dividends. Because the dividend payout formula uses net income, banks that set aside a significant amount of provisions will report lower net income and potentially endanger their dividends. Banks will have to ask "how much do we throw into the reserve in the second quarter? Because it'll be important for them to earn money to maintain their dividend," said Marty Mosby, director of bank and equity strategies for Vining Sparks.
The Federal Reserve's approach attracted criticism from several top economists who argued that the regulator should have suspended all dividends given the level of economic uncertainty in the middle of a pandemic. Governor Lael Brainard dissented from the Fed's decision to cap dividends, arguing that the set-up allows banks to deplete capital. Daniel Tarullo, a former Fed governor who designed the original stress tests, wrote a blog eviscerating the entire process, titling the piece, "Are we seeing the demise of stress testing?"
In addition to the Fed's regularly scheduled stress test, the regulator devised alternative scenarios using more severe downturns based on the pandemic. Some economists said the scenarios showed up to 25% of banks would be unable to withstand a double-dip recession. Others were significantly more positive on the results, arguing that the stress tests showed the banking industry overall has the ability to withstand loan losses up to $700 billion.
"Even under the most stressful version of a downturn scenario which is, I would say, a double dip scenario, in aggregate the banks are maintaining adequate capital above minimum levels," said Bill Forsell, an associate director at consulting firm Protiviti.
Click here to access a template with the Federal Reserve-run 2020 Dodd-Frank Act stress-test results pertaining to loan losses and profitability projections for the 33 participating bank holding companies.