Stress-Test Virgins Seek Fed Blessing on Dividends

They worked through the holidays. They spent millions of dollars on consultants and new staff. They dragooned hundreds of employees to produce thousands of pages for regulators.

Executives at the 12 freshmen banks participating in this year’s Federal Reserve stress tests still might not avoid the fate of larger lenders that failed in prior years, including Citigroup Inc. and Bank of America Corp. They’ll find out later today when the Fed releases results of its annual test of their financial strength.

While bigger firms have been through the process every year since 2009, banks such as Huntington Bancshares Inc. and Comerica Inc. are doing it for the first time. This raises the odds that regulators will find fault in the data or managers and block an increase in dividends and buybacks, according to analysts. Fed officials say the testing is making lenders stronger by spurring sales of bad assets.

“Their first time through, they aren’t as familiar with what they might and might not be approved for,” said Jennifer Thompson, an analyst at Portales Partners LLC in New York. “The advantage of the banks that have been through this process before is they’ve learned a little bit about how the Fed operates.”

Survival Mode

The stress tests cover 30 banks ranging from JPMorgan Chase & Co., the New York-based industry leader with $2.4 trillion in assets, to Salt Lake City-based Zions Bancorporation with $56 billion. About $75 billion in added payouts is at stake, including $4 billion from new participants.

The Fed runs the exercise to ensure lenders would still have enough capital to ride out economic turmoil that might threaten their survival or the stability of the financial system. The goal is to head off public bailouts like those of 2008, when credit markets froze and the U.S. stepped in with a $700 billion rescue program.

Some of the banks that took taxpayer funds had to agree to freeze dividends or cut them to a token amount, with Bank of America’s quarterly payout still at 1 cent, where it’s been stuck since early 2009. The average yield for the 24-company KBW Bank Index stands at 1.7 percent, compared with 4.9 percent at the end of 2007.

Two Conversations

Regulators can turn down higher payouts if the firm doesn’t meet capital minimums or if the test finds weaknesses in management, planning, systems or governance. Some companies can be compelled to resubmit their plans, which is what happened last year to JPMorgan and Goldman Sachs Group Inc. Analysts and lenders see quality flaws as the bigger concern.

“In some ways, that’s the more important category,” said Mark Levonian, a former senior deputy comptroller at the Office of the Comptroller of the Currency who now works at the consulting firm Promontory Financial Group LLC. “That is the one that the Fed is focusing at least as much attention on.”

The most vulnerable include Zions and M&T Bank Corp., two of the smallest participants. Zions missed Fed targets in last week’s first round and has already said its plan will be resubmitted. The bank could end up returning the lowest percentage of total earnings to investors, about 6 percent, even if it wins approval, according to estimates from analysts at KBW, a unit of Stifel Financial Corp. Bankers typically aim to return about 50 percent or more.

What’s Next

With $85 billion in assets, Buffalo, New York-based M&T may return 20 percent of its earnings, the estimates show. M&T has struggled to convince regulators it can thwart money-launderers so it can complete its stalled takeover of Hudson City Bancorp Inc. The outcome of the stress test may affect the deal, according to Sameer Gokhale, an analyst at Janney Montgomery Scott LLC in Philadelphia.

If M&T passes, investors may consider the lender to have complied with anti-money laundering rules to regulators’ satisfaction, Gokhale said. “If they fail the test, it would jeopardize their ability to complete the Hudson City acquisition,” he said.

In the first round, lenders had to show what would happen to capital ratios, revenue and loss rates on various assets in dire scenarios provided by the Fed. This week, they had to prove their plans for dividends, stock buybacks and acquisitions can be carried out without driving those ratios below Fed minimums.

Payout Ratio

The Fed expanded the test this year to include the 12 smaller firms, which each hold more than $50 billion in assets. Northern Trust Corp. and Discover Financial Services round out the domestic lenders, and the central bank is also testing six U.S. units of foreign institutions: BMO Financial Corp., BBVA Compass Bancshares Inc., HSBC North America Holdings Inc., RBS Citizens Financial Group Inc., Santander Holdings USA Inc. and UnionBanCal Corp.

Discover and Northern Trust could lead a 38 percent increase in total payouts over the next 12 months, according to analysts’ estimates compiled by Bloomberg. Comerica is estimated to have the highest total payout ratio, or 84 percent, among the group.

Discover, the credit-card issuer based in Riverwoods, Illinois, disclosed last week that it asked for a 4-cent increase in its 20-cent dividend after the first round showed its Tier 1 common ratio at 13 percent, more than twice the 5 percent Fed minimum. Tier 1 capital is the primary gauge used to determine a lender’s cushion against losses.

Costly Tests

Northern Trust, the Chicago-based custody bank, could raise its total payout 27 percent, according to an average of four analysts’ estimates of potential payouts compiled before the Fed’s first round of tests were announced.

Spokesmen for the companies declined to comment.

Expenses are escalating for the banks participating for the first time and in some cases have taken resources away from generating profits. The average cost to run the test and prepare a submission is $10 million, according to Dan Ryan, head of PricewaterhouseCoopers LLP’s financial regulation practice. These firms each may need to spend $50 million to $100 million to add technology and staff in future years, he said.

“It’s not going away, all these investments that you have to make,” said R. Scott Siefers, an analyst at Sandler O’Neill & Partners LP. “And at a time when revenue is challenging as it is, you’re making it a little more difficult for banks to reduce expenses.”

Potential Flaws

Huntington spent $12 million on its submission with help from outside consultants and about 35 of its own employees, Steve Steinour, chief executive officer of the Columbus, Ohio-based bank, said in an interview last month. The Fed test showed the firm’s Tier 1 common ratio at 7.4 percent, while Huntington’s own analysis pegged the figure at 9.03 percent.

In the past, some banks with significant gaps between their estimates and the Fed’s calculation were asked to resubmit plans because of potential flaws in the quality of the bank’s analysis. Lenders with large disparities this time included Citigroup and Goldman Sachs, both based in New York, and Huntington.

The Fed objected to Citigroup’s plan in 2012, and doubt about Citigroup’s internal controls emerged this year with last month’s disclosure of a $400 million fraud at the company’s Banamex unit. If Citigroup wins approval this year, the payout ratio could rise to 57 percent of earnings from 1 percent, according to KBW estimates.

Dividend Impact

Bank of America, the second-largest lender by assets, beat the Fed’s minimum for the basic leverage ratio by one of the narrowest margins. The ratio is a simpler measure of a firm’s capital cushion.

Shareholders have been pressing for a higher payout since the first quarter of 2009, even after the Fed blocked a 2011 request from the Charlotte, North Carolina-based company. Last year, the bank won approval for a $5 billion share buyback, and it could return 53 percent of total earnings this year, according to estimates from KBW.

“We are somewhat nervous that it or another bank could be failed on a qualitative basis,” said Richard Staite, an Atlantic Equities LLP analyst, referring to Bank of America. “These banks will be able to return capital but will need to improve their capital-planning process during the next six months.”

Quality Counts

Fed officials have said that the more experienced participants are held to the highest set of standards, which will be ratcheted up every year.

Zions, the only bank that came in below the Fed’s main capital minimum in the first round, spent as much as $15 million on outside consultants, assigned 50 people to the project and temporarily diverted 200 to 300 more from revenue-generating tasks to cross-check data, Chief Financial Officer Doyle Arnold said in an interview. He spent New Year’s Eve at the company’s headquarters, putting final touches on the 7,000-page submission.

“That’s the nature of the beast,” he said. Subsequently, the sale of some securities reduced the bank’s risk, which analysts predict will bolster the revised plan.

“It’s a tremendous amount of work, it’s quite expensive and it’s permanently changed the way we think about risk,” Arnold said. “That’s probably on balance a positive for us and for the industry.”