Banks: The Road to Dividends and Buybacks

Markets are mixed this morning, with the S&P 500 down 0.23% and the narrower, price-weighted Dow Jones Industrial Average up 0.1% as of 10 a.m. EST.

Stressing out
What would happen to the equity cushion of the top U.S. banks if the eurozone crisis flared up and the spreads on "A"-rated core eurozone banks tripled? Or what if Brazil's main stock market index were to fall by 42%? These are just two of the assumptions the Fed asked banks to examine in the now-annual "stress tests" of their capital structure. On a static basis, the top four commercial banks are much improved in terms of the strength of their balance sheets (see the second column in the table below) -- leverage has come down markedly in the wake of the financial crisis. The Fed's scenario analysis is critical in assessing banks' resilience in a dynamic environment.


Tier 1 Common Equity Ratio (Basel III)

2011 Payout Ratio

Bank of America






JPMorgan Chase



Wells Fargo



For investors, the results of these tests -- which will be released in March -- are important because they will determine the extent to which banks can return capital to shareholders through dividends and share repurchases. According to the Financial Times, Portales Partners estimates that JPMorgan Chase will return 72% of its earnings to shareholders, while Citigroup and Bank of America will only return a fraction of that ratio.

Beyond the implications regarding capital return, the stress tests are a reminder of the limits of banks' investability: The Fed asked these institutions to test their balance sheets according to 30,000 risk factors!

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Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him @longrunreturns. The Motley Fool owns shares of Bank of America, Citigroup Inc, and JPMorgan Chase & Co. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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