Can dividend investors depend on banks for income? In the wake of the 2008 crisis, the question would have seemed absurd. Following the Lehman bankruptcy, the forced sales of Merrill Lynch, Bear Stearns, Wachovia, and Washington Mutual, and the massive wave of home foreclosures, how could anyone view bank income as dependable?
It can be fashionable to be negative, but it has been ten years. The Federal Reserve has strengthened bank regulation, putting limits on risky activities, and most importantly, requiring banks to operate with more capital. Equity capital is what gives banks a buffer to continue operating through a downturn in the economy. One metric regulators use to gauge safety at a bank is the common equity capital ratio— equity as a percent of risk-weighted assets. In the first quarter of 2009, the common equity capital ratio was about 5% at the nation’s largest banks. By the end of 2017, this ratio had more than doubled to roughly 12%.*
Of course nothing is certain until we go through another credit cycle, but we shouldn’t minimize the efforts that have been made.
The largest banks now go through a stress test annually, involving the Federal Reserve’s independent assessment of how each bank’s loan book would perform in a severe scenario. In the 2018 stress test, the severe scenario was indeed extreme with unemployment topping 10% and equity markets falling by 65%. Clearly this severe scenario would have been too much to endure just following the financial crisis. But it has been ten years. In the intervening years, major US banks hired thousands of additional compliance professionals and spent billions on consultants. Risky assets and businesses were jettisoned. But most of all, a big chunk of earnings was retained, allowing equity capital to rise relative to assets.
Most major US banks came through the 2018 stress tests with flying colors. After years of caution, the Fed is now allowing banks to return capital to shareholders via dividends and share buybacks. For large US banks**, the average dividend increase this year was over 20%. In addition, these same banks were allowed to buy back up to 6% of their outstanding shares. We believe these remarkable approvals are a clear signal from the Fed that the banking system is now well-capitalized and dividend investors can once again view banks as a reliable source of income. Naturally the risk of widespread loan defaults will always exist, but US banks now have the capital buffer to sail through all but the roughest waters without cutting dividends.
Footnotes:
*Source: Federal Reserve press release June 28, 2018
**Included in the 2018 Comprehensive Capital Analysis and Review (CCAR) are US banks with more than $100 billion in total consolidated assets.
