Banks' Dividend Gravy Train Charges Past Regulators

Updated from 9:50 ET with morning market action and comment from Goldman Sachs's equity research team.

NEW YORK ( TheStreet) -- Most bank stocks were up on Tuesday, showing investors' relief that the regulators didn't follow the lead of Senators Brown and Vitter, who in May proposed a radical 15% Tier 1 leverage requirement for the largest U.S. banks.

Bank stocks were weaker on Wednesday morning, with the KBW Bank Index ( I:BKX) down 1%, although that may be reaction to China's report that its exports during June declined 3.1% from a year earlier.

Despite federal regulators' move on Tuesday to greatly increase leverage capital ratios for large U.S. banks, the key factor in banks' capital deployment decisions will be the Federal Reserve's annual stress tests.

Just one week after the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. issued their final rules to implement the Basel III capital standards for U.S. banks, the three regulators on Tuesday doubled the minimum Basel III supplementary Tier 1 leverage capital requirement for the nation's largest financial institutions.

Under Basel III, banks are required to have minimum Tier 1 leverage ratios of 4%, but large, systemically important banks are required to perform a separate supplementary Tier 1 leverage ratio calculation that incorporates off-balance-sheet items. The minimum requirement for this supplementary Tier 1 leverage ratio is 3%.

Except for U.S. banks. The federal regulators have proposed requiring U.S. banks with total assets in excess of $700 billion to maintain supplementary Basel III Tier 1 leverage ratios of 6%. For large U.S. bank holding companies, the minimum ratio is 5%.

The Basel III capital standards and the Fed's annual stress tests for large banks focus on Tier 1 common equity ratios, which are risk-based ratios. This means that assets are weighted by perceived risk, with cash, for example, having a zero risk rating. So a bank's Tier 1 common equity ratio is always higher than its Tier 1 leverage ratio, or its supplementary Tier 1 leverage ratio.

The new rules proposed Tuesday are subject to a 60-day comment period. The rules are to be phased in beginning in 2015, with full compliance required by January 2018.

At this point in the long phase-in of Basel III, investors may be frustrated at another regulatory monkey wrench one week after the final rules were issued. After all, the large banks were all in full compliance, or close to compliance with the Basel III Tier 1 common equity ratio requirements years ahead of the deadline.

Guggenheim Securities analyst Marty Mosby on Tuesday said "the regulators want to make sure that the large-cap banks don't get too comfortable with where their capital requirements are... This leaves some uncertainty out there to encourage them to be more conservative in their deployment of capital."

In a note to clients on Tuesday, Atlantic Equities analyst Richard Staite wrote that he expected the affected bank holding companies to meet the new supplementary Basel III Tier 1 leverage ratio requirement "via retained earnings within the next two years even after buybacks."

"We therefore believe the key factor determining banks' ability to return capital will remain the annual CCAR process and stress test," he wrote. CCAR stands for Comprehensive Capital Analysis and Review, which is the second part of the Federal Reserve's annual stress test process for the largest U.S. financial institutions. CCAR incorporates banks' plans to deploy capital through dividends, share buybacks and acquisitions, to the economic scenarios used in the stress tests.

According to Staite, large holding companies that currently have estimated supplementary Basel III Tier 1 leverage ratios below the new 5% minimum include Goldman Sachs ( GS), with a ratio of 4.9%; JPMorgan Chase ( JPM), with a ratio of 4.7%; Citigroup ( C), with a ratio of 4.6%; and Morgan Stanley ( MS), at 3.8%.

By the end of 2015, Staite forecasts the supplementary Basel III Tier 1 leverage ratio for Goldman will increase to 5.2%, putting the company in compliance with the new rules two years in advance, despite returning an estimated $23.3 billion in capital to investors through dividends and share buybacks during 2013, 2014 and 2015.

Staite expects JPMorgan's supplementary Basel III Tier 1 leverage ratio to increase to 4.9%, even after returning a total of $42.3 billion to investors through dividends and buybacks during 2013, 2013 and 2015. And at the end of 2015, JPMorgan will still have two more years to push the supplementary Tier 1 leverage ratio above 5%.

Such large estimates for JPMorgan's return of capital are quite reasonable when you consider that the company in March was approved by the Federal Reserve to repurchase up to $6 billion in common shares through the first quarter of 2014, while raising its quarterly dividend to 38 cents a share from 30 cents, even though the Fed only granted "conditional approval" to the company's capital plan.

For Citigroup, Staite estimates the supplementary Basel III Tier 1 leverage ratio will be 5.5% at the end of 2015, putting the company comfortably in compliance with the regulators' new requirement, even after returning $26.3 billion in capital to investors during 2013, 2014 and 2015.

Staite estimates Morgan Stanley's supplementary Tier 1 leverage ratio will increase to 4.3% at the end of 2015, meaning the company will still have to build significant capital or reduce its assets sufficiently to be in compliance by January 2018. The analyst still expects Morgan Stanley to return $9.4 billion in capital to investors during 2013, 2014 and 2015.

The analyst also estimates that Wells Fargo ( WFC) is currently in compliance with the proposed rule, with a supplementary Basel III Tier 1 leverage ratio of 6.5%, with Bank of America ( BAC) also in compliance, at 5.0%.

Deutsche Bank analyst Matt O'Connor agrees that the new proposed rules "won't impact capital deployment over the next 3 years at the market sensitive banks and brokers." In a note to clients on Tuesday, O'Connor wrote that he expected "organic build of about 75bps per year in leverage ratios before capital deployment (and 25-35bps post our deployment assumptions) given earnings and as balance sheets for this sub-group are unlikely to grow."

O'Connor expects the large banks to achieve compliance with the new rules in part through asset reduction, "especially of lower risk assets." This makes sense, since the perceived risk of a class of assets has no effect on leverage ratios, which are not risk-weighted. This underlines the uncertainty over the usefulness of leverage ratios. After all, cash really is less risky than a nonperforming loan.

O'Connor also included the issuance of preferred shares as a tool for large banks to achieve compliance with the new rules. "Recall that preferreds can represent up to 1.5% of Tier 1 capital under Basel 3 vs. 0.7% currently (BAC 1.4%, C 0.2%, GS 0.5%, JPM 0.8%, MS 0.3%)."

"While issuing preferreds would be slightly EPS dilutive, the impact would be modest as it would be partially offset by runoff of long term debt," he wrote.

Goldman Sachs's equity research team agrees that stress tests and risk-based capital would still be the main factors when determining dividend payouts and stock buybacks. "While the supplemental leverage ratio may be the binding capital constraint for some banks today, capital return is still likely to be dictated by the annual CCAR exam, which is a more focused risk management tool than a simple leverage ratio," the analysts wrote in a note to clients on Wednesday.

Goldman's analysts added that "while the leverage ratio will serve as a key "check" for capital adequacy, risk-weighted asset inflation in a stress scenario will likely make risk-based capital measures more onerous than the leverage ratio, where assets should remain stable."

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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