The Fed's Bank Stress Tests Are Good News for Stock Dividends -- Here's Why
The recent results of the Federal Reserve's latest stress tests of large U.S. banks are reason for cheer among dividend investors. That's because the potential for dividend growth in the financial sector.
The stress tests attempt to determine whether a financial institution is capable of withstanding an economic downturn, making the tests a natural indicator of company health.
The tests have two parts. In the "quantitative" part, the central bank determines whether the institutions have enough capital to weather a hypothetical recession without requiring government help. This year, all 33 institutions passed this part. In the second part, regulators look at "qualitative" factors, such as whether a bank is capable of correctly measuring the risks it confronts.
The Federal Reserve said that two of the 33 banks failed this second round of the stress tests: the U.S. units of Deutsche Bank and Banco Santander. But all 24 banks in the S&P 500 index passed and are now able to raise their dividends.
As a firm focused on divided-growth investment solutions, Reality Shares has been closely watching forecasted dividend momentum surrounding stress testing for its impact on the overall market dividend growth rate. Stress testing directly affects dividends, as financial institutions failing stress testing are prevented from paying out dividends or any type of capital to their shareholders.
Stress testing began in the aftermath of the Great Recession as a result of the financial crisis that brought down or seriously threatened several financial institutions. In its aftermath, the Federal Reserve created the Comprehensive Capital Analysis and Review to monitor financial institutions in the hopes of preventing any future bailouts.
These tests have come to be known as CCAR, or stress tests, and today determine whether a company over $10 billion in assets can go through a sort of worst-case downturn scenario, weather such difficulty and survive.
Delving Deeper Into the Dividend Growth Investment Insights of Stress Testing
While banks might complain about the difficulty and cost of performing annual stress tests, the tests have provided valuable insight to investors and especially dividend-growth investors. Banks seek to keep or increase their dividends even when it may be financially restrictive, as failing to do so reflects very poorly on the company and its management. Also, being prevented from paying a dividend whatsoever seems unthinkable to most company management teams, as investors in companies under that much financial distress may choose to sell positions or even move to replace underperforming executives.
Bank balance sheets have only improved since the Great Recession, meaning if allowed by the Federal Reserve, many banks could likely be looking to increase their dividend after the stress test announcement. This historically has buoyed stock performance, as we have all seen the research showing that dividend growers significantly outpace nondividend payers. Conversely, companies or banks that cut or eliminate dividends typically see selling pressure and have historically underperformed.
Supportive News for the Dividend Growth Rate
The positive stress test results could mean that there is still much room for dividend growth in the financial sector, resulting in the potential positive impact to the overall market dividend growth rate. The two banks with perhaps the most potential to significantly impact overall dividends are Bank of America (BAC) - Get Report and Citigroup (C) - Get Report . Before the recession, Bank of America paid a dividend of 64 cents a share. When factoring in its reverse stock split, Citigroup paid $5.40. More recently, however, both banks have paid dividends as low as just 1 cent, largely stemming from their difficulties in passing annual stress tests. After passing their latest stress tests, both banks immediately announced dividend increases. Bank of America announced a 50% dividend increase to 7.5 cents a share while simultaneously buying back up to $5 billion in stock. Citigroup indicated it would significantly raise its dividend while buying back up to $8.6 billion of its own stock. These two dividend actions alone increased the S&P 500 dividend by 0.56%..
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Among the other 22 banks listed in the S&P 500, all passed and another 18 immediately announced their intention to increase their dividends. In fact, 17 of the 20 total banks announcing dividend increases exceeded analyst expectations for dividend growth, showing even more potential strength in the financial sector. Because the sector is historically one of the largest payers of dividends in the S&P 500, these positive stress test results could have a much larger-than-expected impact on the overall dividend growth rate.
Fourteen of the 24 banks in the S&P 500 that underwent stress tests were paying dividends at or below pre-recessionary levels, meaning those that pass will potentially be able to grow their dividend.
Room for Dividend Growth in Financials
As of the end of June, the financial sector only paid about 16.36% of the dividend in the S&P 500, with companies in the financial sector paying an average dividend yield of about 2.25%. While these numbers are on par with the overall index, the financial sector has previously paid as much as 30% of the S&P 500's dividend, potentially leaving room for growth.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned. Investing involves risks, including possible loss of principal. Past performance does not guarantee future results. This material is prepared by Reality Shares, Inc. ("Reality Shares®"), and all material or information shared herein is for informational or educational purposes only. Nothing on this web site shall constitute an offer or solicitation to purchase or sell any securities or funds. This material contains general information only and is not intended to represent general or specific investment advice. This material may contain forward-looking statements which involve certain risks and uncertainties. The information contained in the material provided on this web site are derived from proprietary and nonproprietary sources deemed to be reliable, but may not necessarily be all-inclusive and are not guaranteed as to accuracy. No part of this material may be reproduced without the prior written consent of Reality Shares. Reality Shares® is a registered trademark of Reality Shares, Inc.