Stress Test Results: A Ray of Hope?

Following the release of the Federal Reserve’s much-awaited stress test results on Friday, many big banks that were granted the green signal took immediate action to raise their dividends. The Fed allowed America’s strongest banks that have passed the second round of stress tests to operate independently without strict government restrictions that were imposed during the height of financial crisis in 2008.

These banks can now increase dividends and buy back shares, both of which were prohibited for the last few years following concerns that banks might not have sufficient capital to counter another financial crisis.

The results also brought good tidings for the weaker banks. These were given the consent to raise capital by issuing shares to repay the money they received as part of their participation in the government’s $700 billion Troubled Asset Relief Program (TARP).

The Nitty-Gritty of Stress Test

In January, all 19 banks subjected to the stress tests in 2009, had submitted their capital plans to the Fed. These banks were required to demonstrate that they have adequate capital to address potential losses over the next two years under various scenarios.

The environment of the latest round of stress tests was dissimilar to the Fed’s first round conducted in 2009 to estimate how much banks would lose if the economic downturn proved even deeper than expected as the country was teetering under tremendous recessionary pressure. On the other hand, the latest stress test was basically a precautionary exercise amid economic recovery. Also, as the banking industry swung back to profitability in 2010, big banks began pressing regulators to allow them to enhance shareholder value through dividends and buybacks.

However, many banks are still reeling under the damages caused by the economic bust. The Federal Reserve has to maintain its capital deployment restrictions on such banks.

Dividend Raise: To What Extent?

Though the Fed is allowing some banks to increase dividends, the payments will be restricted up to 30% of a bank’s expected earnings for 2011. This is still significantly below the approximately 50% paid prior to the crisis.

However, the 30% threshold is still good. Most importantly, the increase is an indication of economic improvement. Resuming dividend increase from the quantum drop will definitely help these banks access capital over the long term.

Qualified Banks

Wells Fargo & Company (WFC), JPMorgan Chase & Co. (JPM) and U.S. Bancorp (USB) are among the major banks that received clearance to raise their dividends.

Wells Fargo increased its quarterly dividend to 12 cents per share from 5 cents. However, this is depressingly lower than the company’s pre-recession quarterly dividend payment of 34 cents. The company is also planning to resume its share repurchase activity and targeting to start with its 200 million shares repurchase program.

JPMorgan increased its quarterly dividend to 25 cents per share from 5 cents. Also, the company authorized the buyback of $15 billion shares.

U.S. Bancorp more than doubled its dividend to 12.5 cents per share from 5 cents. The bank also authorized a 50 million share repurchase, which it intends to complete by the end of this year.

Another major bank, The Goldman Sachs Group Inc. (GS), received the Fed’s approval to buy back $5 billion of preferred stock from Berkshire Hathaway Inc. (BRK.A). This will allow Goldman to boost its dividend payment.

However, Bank of America Corporation (BAC), which pays a quarterly dividend of only a penny, and Citigroup Inc. (C), which does not pay any dividend, has not announced any immediate increase. While Bank of America expects to raise its dividend payment later this year, Citigroup will have to wait until the next.

TARP Repayment Still Due

Of the total $245 billion handed out to banks, more than $30 billion is still due from about 600 institutions.

Many of the regional banks that have still not repaid the bailout money in full will not be allowed to increase their dividend payments, even if they wish to do so. As soon as these banks repay the bailout money they will be allowed to increase dividend payments, provided they meet the requirements to pass the stress test.

Of the total 19 banks, 3 banks are still to repay the TARP money. These banks are KeyCorp (KEY), SunTrust Banks Inc. (STI) and Regions Financial Corp. (RF). However, following stress test results, KeyCorp and SunTrust announced their plans to clear off TARP funds as they have received authorization to issue shares to raise capital. Only Regions Financial is still mum about any capital action.

The Way to Recovery

This is not the final round. The big banks will have to undergo the Fed’s stress test once every year. The primary intention is to check a bank’s financial strengthen to fight another financial catastrophe.

The economic benefits of the stress tests are indisputable. These would help to build up weak capital levels of banks that would always be a threat to the economy. Also, this could ultimately translate to less involvement of taxpayers’ money for bailing out troubled financial institutions.

However, the government must necessarily set policies so that all industry participants contribute to the overall profitability. While the bigger banks benefited greatly from the various programs launched by the government, many smaller banks are still trying hard to catch up.

No matter what, the approval from Federal Reserve to increase dividend payment will definitely accelerate the pace of economic recovery.

By: Kalyan Nandy

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