[Updated: July 17, 2017]
The Federal Reserve’s annual financial health check up on America’s largest banks passed with flying colors last month, enabling the country’s top lenders to increase their dividend payments. The results of the Fed’s latest stress tests suggest the U.S. financial sector is stabilizing after a prolonged bout of uncertainty caused by geopolitical unrest and slowing economic growth.
In this year’s stress tests, the Federal Reserve gave the green light to 34 financial institutions, concluding that America’s largest banks have the capital buffers needed to keep trading through a major economic downturn. Officials concluded that the banking sector would endure a $493 billion loss under the most severe scenario simulated by the central bank.
The tests marked the first time in seven years that all institutions were granted permission to buy back stocks or pay dividends to shareholders. This amounted to a record level of post-crisis distributions, including almost $100 billion in payouts from the nation’s six largest banks.
As a result, the nation’s top-five banks by assets – Citigroup Inc. (C ), Bank of America Corp (BAC ), Goldman Sachs Group Inc. (GS ), JPMorgan Chase & Co (JPM ) and Wells Fargo Group (WFC ) – have either announced plans to raise their dividends or expressed intent on doing so.
Goldman Sachs and JPMorgan are part of the Dow 30, a coveted list of American blue-chip companies.
What is the Stress Test?
The 2008 financial crisis put Wall Street under a well-deserved microscope. Deemed too big to fail, financial institutions received lofty bailout packages after the subprime mortgage crisis that triggered public outrage. Since then, the Federal Reserve has taken the initiative to more actively monitor systemic risks in the financial sector. That’s why the Fed conducts annual stress tests or hypothetical scenarios that gauge how the major U.S. banks would perform in adverse economic conditions, such as a recession or financial crisis.
This year, all 34 participating banks passed the tests – the first such feat since the financial crisis. This is impressive given that regulators have steadily expanded the hurdles to pass the stress tests each year. It’s clear from this result that the banks are stronger than at any point since the Great Recession.
Banks and their shareholders closely watch the results of the annual stress tests, which have been released at this time of year since 2011 when the Federal Reserve ruled that banks would have to submit to stress tests on an annual basis. That is because the result of the stress tests largely determines whether banks are able to increase their cash returns to shareholders, including dividend increases and share repurchases.
As one can imagine, stress tests aren’t popular among the major financial institutions. For starters, they face significant compliance costs – in the billions of dollars – to submit and comply with stress test hurdles each year. Moreover, banks have widely stated that the Federal Reserve is risking choking economic growth with over-regulation. However, at the same time, banks have also acknowledged they are in much better financial condition than at any point since the financial crisis due to the stress tests.
Positive Results Allow for Increased Capital Returns
The results of the stress tests enabled Citigroup to immediately double its quarterly dividend to 32 cents per common share. The bank also announced a common stock repurchase program worth up to $15.6 billion, surpassing its 2015 buyback of $15 billion.
Bank of America also announced plans to increase its quarterly payout to 12 cents per common share beginning in the third quarter of 2017. That represents an increase of 60%. The bank’s board also authorized a $12 billion stock repurchase program, which is set to run from July 1 through June 30, 2018. This included an additional $900 million in repurchases to offset stocks awarded in equity-based compensation plans.
Goldman Sachs confirmed that the stress test will allow the bank to continue returning capital to shareholders while expanding its client franchise. However, the New York-based multinational gave no details on its plan to boost dividends or initiate share repurchases.
JPMorgan Chase raised its quarterly payout by 6 cents to 56 cents a share, effective in the third quarter of 2017. The financial giant also authorized share buybacks of up to $19.4 billion – the largest in history – set to take place between July 1 and June 30 next year.
Meanwhile, Wells Fargo said it will raise its common stock dividend by 1 cent to 39 cents for four quarters beginning in Q3 2017, pending approval from the board. The bank will also initiate $11.5 billion of common stock repurchases, significantly higher than the $8.3 billion it issued in the four quarters ended in Q1 2017.
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You can also explore the dividend yield of the financial sector by clicking here. This page gives you access to the company count and dividend yield of industries within the financial sector.
Banks Hold Attractive Valuations
The results of the stress tests clearly show that Wall Street banks have enough armor to shield depositors from another major crisis. Their return to health comes at a time when the U.S. economy is gradually expanding, fueled by job creation and rebounding factory output. At the same time, however, the economy is struggling with weaker inflation and uneven consumer spending – factors that have been flagged by the Federal Reserve.
The Fed is moving forward with its plan to raise interest rates gradually. Policymakers have raised the federal funds rate three times in six months and plan to do so again before the end of 2017. The statement that concluded the June Federal Open Market Committee (FOMC) meeting also indicated that policymakers will soon begin winding down the central bank’s bloated $4.5 trillion balance sheet.
An environment of rising interest rates is expected to boost bank profitability as the major institutions pass on higher costs to their consumers. The banking sector has outperformed the broader S&P 500 Index over the past 12 months and has been one of the strongest contributors to the post-election rally.
For instance, consider Citigroup. The bank started 2017 in fine form as it beat on earnings and revenue. However, its second-quarter profit declined 3% as the bank parked more money to cover bad loans. The financial giant earned $1.28 per share, compared to $1.24 per share a year ago. Citi had net interest revenue of $11.17 billion, up 6% from Q1 2016, as rising interest rates allowed the bank to charge more to borrow. However, Citi’s P/E and P/B ratios put it on a lower rung of the major bank category.
Bank of America’s top and bottom line results were higher than expected in the first quarter, with net interest meeting expectations. The bank also said its loan business expanded 6% in the first quarter, raising optimism about its future. It therefore comes as no surprise that the bank’s share price has been on a tear on a trailing year basis, up more than 80%. BAC’s net interest income has surged in recent quarters, reaching $11.06 billion through the first three months of the year. That represents a gain of 20% compared to the June 2016 quarter. At 14.9, BAC has the highest P/E ratio of the major banks. When it comes to BAC, most signs are positive thanks to improved credit portfolio and rising NIM.
Goldman Sachs has been among the Dow 30’s best-performing stocks over the past 12 months despite posting disappointing first-quarter results. Goldman posted earnings per share of $5.15 on revenue of $8.03 billion. Both figures were well below forecasts. Net interest income rebounded to $516 million on the quarter, but remained well below year-ago levels. Goldman’s price-to-earnings ratio is 12.2, which is well below the financial industry average.
JPMorgan – the nation’s biggest bank by assets – reported huge gains in second quarter earnings revenues and revenue. The bank’s net income rose 14% to $7.03 billion, or $1.82 per share. However, the bank said net interest for the full year would increase by $4 billion, rather than the $4.5 billion forecast given in April. JPMorgan says the downward revision is due to mortgage adjustments and the realignment of interest rates. The company’s high P/E suggests that investors are expecting higher earnings in the future.
Wells Fargo posted higher second-quarter results thanks in large part to net interest income, which rose 6.4% to $12.48 billion. For the quarter, the bank reported net income of $1.07 per share on revenue of $22.17 billion. At 13.68, Wells Fargo has one of the highest P/E ratio of the top-five banks. At 1.6, it also has the highest P/B.
Below is a summary of the valuation metric for the five banks. The ratios are based on closing prices as of July 14, 2017.
Despite their underlying health, the major banks could face headwinds expanding their earnings as the so-called Trump reflation trade ebbs through the second half of the year. Hopes of imminent structural reforms, tax cuts and deregulation have slowly faded as the Trump administration struggles to implement its pro-growth agenda.
It’s also important to note that all five major banks have an average P/E ratio that is well below the financial industry. This is certainly true of Goldman Sachs and Citigroup. That being said, a low ratio shouldn’t deter income investors from including these stocks in their portfolio. For starters, they’ve posted spectacular gains over the past year and are poised to enjoy stronger net interest income as the Fed raises interest rates.
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The Bottom Line
The Great Recession officially ended eight years ago, but America’s largest banks are only now emerging from its shadows. Banks have placed greater emphasis on shoring up their finances, diversifying their business and shielding their exposure to systemic risks. As the financial sector returns to health, higher dividend payments from the top-five banks could become the norm.