Bank Stress Tests Could Lead to Higher Dividends for These Investors

The U.S. Federal Reserve will announce results of its annual bank stress tests Thursday - which means higher dividend payouts could be on the way from a handful of U.S. banks.

The bank stress tests are designed to assess if big U.S. financial institutions can weather a major economic storm.

Then, on March 14, the Fed will announce whether or not it approves of the banks' plans to distribute profits to shareholders.

The two-stage announcement process was put into place to give banks a chance to amend their payout plans, depending upon the results of the stress tests, before announcing them publicly. The Fed must approve any plans for the nation's biggest banks to distribute profits to shareholders after assessing the impact of those distributions on the banks' capital.

"You've gone from a few years ago, when the industry as a whole didn't have enough capital, to the point where in the not- too-distant future, it's going to have too much," Jason Goldberg, a New York-based banking analyst at Barclays Plc, told Bloomberg News. "The Fed's endorsement is "a Good Housekeeping seal of approval.'"

How the Bank Stress Tests Work

Since 2011, the bank stress tests have used the Comprehensive Capital Analysis and Review approach to determine if banks have sufficient capital to handle a major economic downturn.

This year, two hypothetical scenarios were used. The first assumed that the economy contracted for six consecutive quarters and that inflation and interest rates rose sharply. The second scenario assumed that unemployment rose to 12% and that the stock market fell by 52%.

Both scenarios assumed dividend payouts would remain unchanged and that there would be no share buybacks.

In 2012, 15 of the 19 biggest banks passed the stress test and were given the green light to increase payouts to shareholders. Notable among the banks that failed the stress test was Citigroup Inc. (NYSE: C), which was one of the reasons for the 2012 ouster of former CEO Vikram Pandit.

Bank analysts expect all 19 banks to pass the stress test this year so that raises the question of how much shareholders can expect payouts to increase.

Higher Dividends, Bigger Buybacks

Analysts expect Citigroup to be able to increase its quarterly dividend to between 10 cents and 20 cents from the current 1 cent and to repurchase $1.17 billion worth of shares through March 2014.

Bank of America Corp. (NYSE: BAC) had its payout plans rejected in 2011 and left its quarterly dividend unchanged at 1 cent in 2012. Analysts expect BAC will be able to pay out between 10 cents and 30 cents to shareholders this year through a combination of dividends and share buybacks.

Looking ahead to 2014, if BAC's earnings increase as expected, the quarterly dividend could be as high as 9 cents, giving the stock a yield of 3.0% at Wednesday's share price.

Another analyst favorite is Wells Fargo & Co (NYSE: WFC). WFC currently pays a 25-cent quarterly dividend for a yield of 2.78%. WFC has increased its quarterly earnings for 12 consecutive quarters and is expected to continue to improve earnings in 2013.

Today's 25-cent quarterly dividend represents only a 27% payout ratio based on consensus estimates for 2013 earnings. Management has signaled that it wants to increase its payout to shareholders to more than 50%, which would make a quarterly dividend of 50 cents by the end of this year entirely feasible, though some of the payout is likely to come in the form of share buybacks.

Among the more well-capitalized banks, WFC's share price has lagged competitors such as Goldman Sachs Group Inc. (NYSE: GS) and JPMorgan Chase & Co. (NYSE: JPM). Although both of these banks are expected to pass their stress tests with flying colors and to increase shareholder payouts, WFC may offer the best combination of yield and potential for capital gains during 2013.

Most analysts expect bank share volatility to pick up during the week between Thursday's stress test announcement and the approval/disapproval of planned shareholder payouts on March 14.

This is the first time that the Fed will execute its bank stress test announcement in two stages. It remains to be seen if this will have a calming effect on the market or if it will increase volatility.

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