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Dilantha De Silva
Dilantha De Silva
Articles (101)  | Author's Website |

Bank Dividends Are Likely to Come Under Pressure

Pressure mounts on the financial services sector to abandon shareholder distributions

Dividends play a major role in the performance of an investment portfolio. For this reason, many value investors tend to prefer dividend-paying companies in the hopes of generating a reliable source of income in the current period in addition to the expected capital gains in the future. The big banks in the United States have a history of returning billions of dollars to shareholders, so, for this reason, are adored by income-seeking investors. According to data from Eikon, the financial services sector yields 3.36% as of June 29, ranking fourth in the highest-yielding list. There is, however, an unpleasant reality waiting for investors in the form of dividend cuts later this year. The annual stress test results released by the Federal Reserve on June 25 paint a bleak outlook for the ability of banks to continue rewarding investors if macroeconomic conditions deteriorate further.

The data released by the Fed

According to the rules outlined in the Dodd-Frank Wall Street Reform and Consumer Protection Act that was passed in response to the global financial crisis, the Federal Reserve conducts annual stress tests for banks with over $100 billion in assets to determine whether these institutions need to strengthen their liquidity position. With the passing of this policy, regulators were given the power to force banks to increase their reserve requirements to avoid a catastrophic event that could lead to a failure in the financial system.

In the annual evaluation for 2020, the Fed decided to incorporate a few possible recovery scenarios to assess the true impact of the current recession on the banking sector. Even in a severely adverse scenario, most banks are expected to maintain capital ratios above that of the minimum requirement.

Source: Federal Reserve.

Even though this is an encouraging sign, the Fed went on to limit the ability of banks to transfer wealth to shareholders. For instance, all banks are prohibited from increasing dividends in the third quarter, and stock repurchases should be abandoned altogether. In addition, a bank would only be allowed to pay in dividends an amount less than its net earnings for the preceding four quarters. This could prove to be a massive blow for many players in this industry as billion-dollar write-offs and loan loss provisions are likely to make it difficult for a few banks to turn a profit this year. Dividend distributions of such banks, therefore, will have to be cut to meet with the latest regulatory guidelines introduced by policymakers.

Below are the expected common equity tier 1 capital ratios in the severely adverse scenario for a few large banks in the United States.

Banks

Expected common equity tier 1 ratio

Bank of America Corporation (NYSE:BAC)

9.6

The Bank of New York Mellon Corporation (NYSE:BK)

12.3

Citigroup Inc. (NYSE:C)

10.3

JPMorgan Chase & Co. (NYSE:JPM)

9.8

Morgan Stanley (NYSE:MS)

11.1

U.S. Bancorp (NYSE:USB)

8.9

Wells Fargo & Company (NYSE:WFC)

9.1

Source: Federal Reserve

Based on this information, U.S. Bancorp and Wells Fargo would come under massive pressure if the American economy does not recover as expected in the next few quarters. Income investors, therefore, might need to allocate their assets to banks that could continue to honor shareholder distributions in the worst-case scenario as the macroeconomic environment is still uncertain.

Wells Fargo is already struggling

Confirming the conclusions drawn in the previous segment, Wells Fargo announced on June 29 that its quarterly dividend will be slashed in the next quarter to strengthen its liquidity position. In a statement to shareholders, CEO Charlie Scharf wrote:

“These are extremely challenging times for many and we remain committed to supporting our customers and communities, and we will continue to take appropriate measures to maintain strong capital and liquidity levels and to improve the earnings capacity of the company.”

On June 29, all other leading banks confirmed their ability to maintain dividends at the current rate. However, depending on the path to recovery for the American economy, things could change in a matter of weeks and the Fed is likely to intervene in the decision-making process every quarter until business activities return to normal.

European banks were forced to abandon dividends

In March, The European Central Bank advised regional banks to suspend dividends at least until October in a bid to save much-needed capital that might be required to keep the banks alive if economic growth remains at subdued levels for longer than expected. Following this regulatory update, a few major banks, including ING Group NV (NYSE:ING), Bank of Ireland Group PLC (BKRIF), Unicredit S.p.A (UNCFF) and KBC Group NV (KBCSF) decided to abandon dividends until the end of the third quarter.

Pressure mounts on banks to suspend distributions

The initiatives taken by European regulators have exerted pressure on American policymakers to be proactive in avoiding an undesirable situation. As a first step, the Federal Reserve decided to limit the ability of banks to raise dividends. However, this is just the beginning of many measures the policymakers would introduce. On June 26, Fed governor Lael Brainard wrote:

“This is a time for large banks to preserve capital, so they can be a source of strength in a robust recovery. I do not support giving the green light for large banks to deplete capital, which raises the risk they will need to tighten credit or rebuild capital during the recovery. This policy fails to learn a key lesson of the financial crisis, and I cannot support it.”

In an opinion piece published by The Financial Times in May, International Monetary Fund Chair Kristalina Georgieva encouraged banks around the world to preserve capital by abandoning dividend payments. She suggests that the sacrifices of investors today will enable financial institutions to reward them for a longer period with no obstacles. Making the case for suspending dividends, she wrote:

“After the 2008 financial crisis, global regulators required banks to increase their prudential buffers of high-quality capital and liquidity. That significantly strengthened the resilience of the financial system. Many observers now cite those buffers as a bulwark against the adverse effects of the Covid-19 pandemic. But as we brace ourselves for a deep recession in 2020, and only partial recovery in 2021, this resilience will be tested. Having in place strong capital and liquidity positions to support fresh credit will be essential. One of the steps needed to reinforce bank buffers is retaining earnings from ongoing operations. These are not insignificant. IMF staff calculate that the 30 global systemically important banks distributed about $250bn in dividends and share buybacks last year. This year they should retain earnings to build capital in the system.”

U.S. banks might eventually succumb to this pressure and decide to follow European banks. This risk should be factored in by investors before deciding to bet on the prospects of this industry.

Takeaway

Data from GuruFocus indicates that the financial services sector is trading at a Shiller price-earnings ratio of 16.10, whereas the S&P 500 index is trading at a multiple of 28.50. This is a clear indication that banks are relatively cheap. Warren Buffett (Trades, Portfolio), on the other hand, continues to believe in the success of this industry. Berkshire Hathaway Inc. (BRK.A)(BRK.B) has a high concentration in this sector with 37% of its portfolio invested in financials. These are encouraging signs, but banks might have to reduce their shareholder distributions, which would not bode well with income investors. Accounting for this risk by applying a valuation discount to the intrinsic value estimate of banks seems to be a prudent decision.

Disclosure: I do not own any stocks mentioned in this article.

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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I'm a CFA level 2 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). During my free time, I enjoy reading.

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