JPMorgan, Citi Get 'Comfortable' With Dividends as Fed Relaxes Stress Tests

Banks are winning the race -- by going as slowly as possible.

Ever since the financial crisis of 2008, regulators have been pushing JPMorgan Chase (JPM) , Bank of America (BAC) , Citigroup (C) and other big U.S. lenders to bolster their capital -- the buffer of extra assets that's supposed to help prevent a collapse when losses swell. The aim was to prevent government bailouts and protect the global financial system from market turmoil that would presumably follow the failure of a gargantuan financial institution.

Instead, regulators are increasingly letting banks pay out billions of dollars of capital to shareholders in the form of dividends and stock buybacks. The result is that the lenders could take until 2019 to meet the capital levels that regulators and U.S. lawmakers have prescribed.

Federal Reserve Governor Daniel Tarullo, the central bank's leading voice on bank regulation, told Bloomberg last week that lenders might not have to incorporate planned capital "surcharges" into their annual payout requests until 2018, with a phased-in approach to follow. What's more, according to Tarullo, the central bank plans to relax the so-called stress tests that are used to evaluate the requests -- implying bigger payouts would be allowed.

"By the time they phase it in, we might be in another crisis, and they'll phase it out because it'll be too expensive for the banks," said Gerald Hanweck, a former Fed economist who's now a finance professor at George Mason University.

While the banks have increased their capital significantly in the years since the crisis, the slow march leaves open the question of whether it's enough. The 10 largest U.S. lenders paid out combined dividends of about $80 billion during the runup to the financial crisis in 2007 and 2008 -- only to require government bailouts later to head off a total market collapse.

The lack of urgency comes amid deteriorating operating conditions for U.S. banks, which face a slowing global economy, surging losses on loans to the beleaguered oil industry and near-zero interest rates that have crimped income from lending and holding fixed-income securities.

The PowerShares KBW Bank Portfolio exchange-traded fund, which tracks U.S. lenders, tumbled 2.2% on June 4 after a report showed the economy added just 38,000 jobs in May, well below analysts' average estimate of 155,000. A dour economic outlook could delay Fed rate increases, depriving banks of a much-hoped-for boost in interest income. Some hedge-fund managers, including billionaire investor George Soros, say that China, the world's second-largest economy, is saddled with so much debt that it's probably headed for a sharp slowdown. 

Even so, from July through June 2017, JPMorgan, Bank of America, Citigroup, Goldman Sachs (GS) and Morgan Stanley (MS) will probably pay out $40.4 billion of capital, Deutsche Bank estimates. That's a 19% increase from the current pace and almost double the amount they paid out in the prior period.

"We doubt that the Fed would require such a large step-up in capital that banks would have to materially lower their payout ratios," Morgan Stanley's own financial-institutions analyst, Betsy Graseck, wrote last week in a note. Citigroup's dividend could more than double in the coming year, while Bank of America's could jump by 75%, according to Graseck. JPMorgan should see a 9% increase, she estimated.

The results of this year's stress tests are due on June 23, while the Fed's analyses of banks' payout plans will come on June 29. Under the tests, regulators analyze whether banks would have enough capital to withstand a financial crisis or other severe operating conditions, such as a period of time where interest rates turn negative.

Citigroup's 30% discount to tangible book value, a measure that accounts for liabilities, and its solid regulatory standing "cannot be overlooked, especially ahead of the Fed's stress tests," TheStreet's Jim Cramer, who holds the stock in his Action Alerts PLUS charitable trust portfolio, said in a note to clients last week.

EXCLUSIVE LOOK INSIDE: Want to be alerted before Jim Cramer buys or sells Citigroup? Learn more now.

Fitch Ratings said in a June 1 report that U.S. banks' average payout request rose to 1.2% of stressed capital in 2015 from 0.8% in 2013, and that the level is likely to be even higher in 2016. The lenders are becoming more "comfortable" and "creative" in their approaches to the annual stress tests, according to the ratings firm.

Last year, JPMorgan, Goldman Sachs and Morgan Stanley failed parts of the stress tests, only to pass after adjusting their proposed payouts. In an interview, Fitch Senior Director Julie Solar compared the process to a mulligan in an informal round of golf, where players get to retake a shot with no penalty after they slice it into the woods.

"It doesn't seem like there's been much of a stigma with using the mulligan," Solar said. The experience may encourage banks to get more aggressive in their payout requests, she said.

Providing further relief, the banks themselves have retooled balance sheets to shift away from an asset-deposit mix deemed to be riskier -- moves that should result in reduced capital requirements, according to Susan Roth Katzke, an analyst at Credit Suisse.

In 2015, for example, JPMorgan estimated that it would have to satisfy a big-bank capital surcharge of 4.5% of risk-weighted assets, putting its overall target for un-stressed capital at 12% by the end of 2018, according to an annual report.

In this year's annual report, the bank declared that it had reduced certain types of deposits, hard-to-value assets and some trading positions, so that its surcharge is now calculated to be 3.5%. And with that, JPMorgan has already met its new goal for un-stressed capital of just 11%.

Bank of America managed to cut its surcharge to about 2.5% from 3%, while Citigroup's is down to 3% from 3.5%, Katzke wrote in a May 16 report

This is "good for the banks," according to Katzke.

Whether it makes them safer, or less risky, is another question.

"I don't think you can really draw too many conclusions other than that they took some actions, and they shrunk their systemic score," Fitch's Solar said.

See full coverage on the Fed's upcoming interest-rate decisions.

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