Expect 'Gradual' Increase in Capital Returns Following Bank Stress Tests: Goldman

NEW YORK ( TheStreet) -- A much-awaited catalyst for bank stocks is finally here.

After the market close on Thursday, the Federal Reserve will release the results of its 2013 bank stress tests, assessing whether the nation's 19 largest banks would be able to withstand a significant deterioration in economic conditions.

Then, on March 14, the regulator will reveal which of the 19 largest banks will be allowed to raise dividends or repurchase shares.

Banks will have to show that they can absorb substantial losses under adverse scenarios, pay out dividends or buy back shares and still maintain Tier 1 common equity ratios of at least 5%.

The Fed's "severely adverse" scenario features an unemployment rate of 12%, a decline in GDP of 5% between the third quarter of 2012 and 2013 and a 20% decline in housing and commercial real estate prices by the end of 2014.

For the first time, banks will have the option of lowering their capital return requests before the results are officially released to improve their chances of winning approval.

Read more on how the tests are structured in Bank Stress Tests are Cruel But Fair.

Goldman Sachs analysts said in a report Monday that almost all banks undergoing the annual review will announce higher capital returns in 2013, given that capital levels are higher than last year, loan books have been further de-risked and the stressed economic scenarios are less severe compared to last year.

Still, "investors should expect gradual, not outsized, increases in capital return" the analysts said. The management commentary at most banks has suggested that they will be conservative in their capital return requests.

"Management teams do not appear to view 'taking a mulligan' as a viable option (i.e., resubmitting their CCAR request with lower capital payouts after their original plan was rejected by the Fed), as they believe a public failure would reflect poorly on their risk management practices and perhaps damage their relationship with regulators," the analysts said.

Banks have indicated that they would like to increase dividend payout ratios before opting to buy back more shares.

Bank stocks have rallied, making buybacks less attractive. JPMorgan Chase ( JPM) CEO Jamie Dimon recently said that a special, one-time dividend might be a more preferable alternative to buybacks.

Investors are hoping that Citigroup ( C) and Bank of America ( BAC) will increase their dividends. Both banks currently pay annual dividends of $0.04 a share.

Citigroup's capital return request was rejected last year, while Bank of America's was rejected the year before. Both banks are keen on avoiding public rejection.

"While Citi and Bank of America have strong capital ratios currently and could theoretically beat our estimates and increase their payout ratios to a level consistent with peers and still 'pass' the stress test, we think an outsized increase in capital return for these names is unlikely in 2013 given: 1) the Fed seems to be imposing a "walk before you run" policy for large-cap banks and 2) recent statements from management teams indicating their first priority is 'passing' the stress test, not increasing returns," Goldman analysts noted.

The analysts also do not expect big capital deployment from Capital One ( COF) as it is focused on rebuilding its capital levels after its acquisition of HSBC's U.S. credit card portfolio.

According to the report, Discover Financial Services ( DFS), Northern Trust ( NTRS) and BB&T ( BBT) are best positioned to increase capital returns while SunTrust ( STI) and Regions Financial ( RF) are set to initiate meaningful capital returns to shareholders.

-- Written by Shanthi Bharatwaj from New York
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