Stressing Over Banks?

Story Highlights:

• Debate over whether US banks should be allowed to increase dividends was largely resolved Friday.
• The Fed’s tests resulted in most banks being able to move forward with their capital plans.
• But stress testing for macroeconomic risk isn’t very telling for investors today.

In the midst of a stressful week dominated by back-and-forth headlines regarding the Libyan conflict and Japan’s earthquake aftermath, news of another type of stress test broke Friday.

Debate over whether US regulators (namely, the Federal Reserve) should permit certain banks to increase dividends, buy back stock, and redeem government investments made under the Troubled Asset Relief Program (TARP) has swirled for months. Proponents argue the banks’ capital plans (rewarding shareholders by sharing earnings, removing costly government capital from their books, and buying back stock to reduce share dilution created by earlier capital raising) are a plus—increasing the attractiveness of bank stocks and improving banks’ long-term ability to raise capital. Opponents largely claim banks should be forced to maintain this excess capital to further bolster potential bad loans.

Much of the opposition’s argument seems like a rehash of battles fought years ago over federal bailouts. Then, the idea of “too big to fail” banks getting bailed out by the government while rewarding shareholders was unseemly to some. But most data don’t support this view. As of Thursday, banks have repaid 99% of TARP funds. Combined with vastly improved US bank health, these two facts would seemingly nullify most objections. But even ignoring these facts, would banks really commit suicide by dividend en masse absent some regulatory watchdog to nix the plan? We think not. Accordingly, some banks may choose not to hike dividends to retain more earnings, while those with bigger existing capital buffers might increase payouts. Folks, some risk will exist no matter what regulators do—and thoughts to the contrary are misguided.

Responding to the debate nevertheless, the Fed undertook the Comprehensive Capital Analysis and Review(CCAR)—a stress test—to determine if 19 large banks should be permitted to execute their capital plans. To pass, banks had to demonstrate likely solvency after implementing their capital plans assuming a hypothetical stress scenario of a new US recession, unemployment higher than today’s, an equity bear market, and further housing value declines. In addition, banks’ readiness for Basel III and the Dodd-Frank financial regulatory reform were considered. Unsurprisingly to us, the plans submitted were largely approved.

There’s a great disparity of ideas among investors about the state of US banks, and it’s easy to see why. Consider just the short list below:

• Bank health has changed from dire (under FAS 157’s fair value accounting rules) to good today.
• US bank stocks currently trade below the past 20 years’ average price-to-book ratio.
• Some will soon boost dividends (though dividends may or may not be positive for investors).
• Banks have been stress tested...and then stress tested again.
• They’ve been reformed by Dodd-Frank. And Basel III. And the Credit CARD act.
• They’ve worked through elevated foreclosures, bank failures, TARP, and an alphabet soup of other government plans.

But are US bank stocks attractive today? The answer isn’t clear cut as the past few years’ regulatory and sentiment backlash is likely not done. Many investors’ bias from 2008 remains strongly stacked against Financials. Abroad, UK banks recently faced Merlin’s wand and EU banks face more stress tests in the coming weeks—adding to global uncertainty over banks. Plus, one can’t ignore other unresolved European questions. The CCAR is emblematic of this continuing backlash: Most non-bank companies don’t have to ask the government’s permission to increase dividends, and neither would non-banks raising dividends stir controversy.

When weighing opportunities presented by the ongoing global bull market and expansion, there are opportunities to outperform global markets in what we feel is likely an overall hum-drum year for index returns. While the last few years have seemingly trained investors to analyze the macroeconomic risk posed by wide-scale bank failures (which government stress tests attempt to answer), today the question is different: Do US banks (as a group) pose a greater opportunity than can be found elsewhere?