Bank 'Stress Test' Twist May Damp Buybacks, Dividends

NEW YORK ( TheStreet) - Banks should not have trouble passing the Federal Reserve's stress tests in early 2013, but investors who expect more aggressive buybacks and dividend plans should tone down their expectations.

The central bank will conduct its annual Comprehensive Capital Annual Review (CCAR) "stress test" of the 19 largest U.S. banks. The purpose of the test is to assess whether banks have sufficient capital to withstand a severe shock to the economy. The Fed uses the test to determine whether banks can go ahead with their plans to deploy capital in the form of dividends and buybacks.

In recent years, banks have shored up their capital base sufficiently to "pass" the stress test, but it has not been smooth for all banks. Notably Bank of America ( BAC) and Citigroup ( C) have seen their requests for capital denied by the regulator.

In the upcoming test, banks will for the first time have the flexibility to make one downward revision to their original capital plan.

According to Bank of America Merrill Lynch analyst Erika Penala, while the "do over" reduces the risk of the banks "failing" or more technically receiving capital objections, companies might still not be particularly aggressive in their capital requests.

The analyst says a handful of management teams have suggested that overly ambitious capital return requests may cause banks to "lose credibility" with the Fed.

The regulator also plans to publish the initial and subsequent request if a downward revision occurs, which could be perceived negatively by the market.

Moreover, while the banks may have no trouble passing the "severely adverse" case in the stress test, "the inflation scenario outlined in the "adverse case" may have an unexpected impact on capital requests for 2013," according to the analyst.

The inflation scenario could be very dilutive to tangible capital, according to Penala's analysis. But it isn't clear how this will impact capital return approvals. Some management teams believe the Fed's inclusion of the measure was "purposeful" and that it might be used to make a decision on capital return.

This could impact banks with a huge exposure to mortgage-backed securities and low overall securities yield.

Despite these concerns, Penala still expects buybacks to triple in 2013, with JPMorgan Chase ( JPM) and Citigroup ( C) poised to return $4 billion and $15 billion next year.

Among the regional banks, Regions Financial ( RF) and BB&T ( BBT) are her top picks. These banks might ask for debt extinguishment, boosting net interest margins and earnings power.

-- Written by Shanthi Bharatwaj in New York.
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