The Federal Reserve recently concluded its annual review of banks, called the stress test. This test is designed to analyze how the nation’s major financial institutions would fare under adverse economic scenarios, ranging from a mild recession to a full-blown financial crisis.
In the post-Great Recession era of too-big-to-fail, banks that are deemed systemically important must undergo and pass the Fed’s stress test each year. If they do, they are permitted to return higher levels of cash to shareholders, through increased dividends and share buybacks.
This year, 31 out of 33 banks passed the stress tests, with only two European banks failing to meet the Fed’s targets. As a result, several companies, including Bank of America (NYSE: BAC), Citigroup (NYSE: C), and Morgan Stanley (NYSE: MS) raised their dividends and announced billions in new buybacks.
Big Banks in a Tough Climate
In the past few years, the big banks in the U.S. have made significant progress in improving their balance sheets and returning to consistent profitability. Still, many continue to be weighed down with high legal expenses, indicating that the scars left by the financial crisis have not completely healed.
For example, two years ago Morgan Stanley incurred $3.1 billion of litigation costs, and another $1.1 billion of compensation expense deferrals. That same year, Citigroup had to take a $3.8 billion charge to settle legal claims relating to its mortgage-backed securities and collateralized debt obligations activities.
If this weren’t difficult enough, the climate is even more challenged because of the persistence of historically low interest rates. Although the Fed did increase rates in December last year, which was the first rate hike in nearly a decade, the recent dip in the labor market and the Brexit vote could keep the Fed on hold for the remainder of the year.
This is a headwind for big banks, because they badly need higher interest rates to improve profitability. Banks suffer from low rates because it reduces their net interest income, which is the spread on the interest banks pay on deposits versus the interest earned on longer-dated loans like mortgages. Low rates have kept banks’ revenue and profit stuck in neutral.
Citigroup’s revenue declined 1% last year, and its net interest margin remained flat in the first quarter, at 2.92%. In similar fashion, Bank of America’s net interest income declined 1.8% last year, and it also reported a decline in non-interest income as well. As a result, Bank of America’s revenue fell 2% for the year.
Big Banks Boost Dividends
The good news is that bank balance sheets are in better condition than at any point since the financial crisis, which gives them financial flexibility to return more cash to shareholders. Morgan Stanley was notified it needs to resubmit its capital plan, but this does not prevent it from returning more cash to shareholders.
Morgan Stanley announced a 33% dividend increase and a new $3.5 billion stock buyback. Meanwhile, Citigroup more than tripled its quarterly dividend payout, from $0.05 per share to $0.16 per share. It also approved a new $8.6 billion share buyback. For its part, Bank of America raised its dividend by 50% increased its buyback by $5 billion.
Dividend Yields of Big Banks
With much higher dividends going forward, big banks are looking more interesting for income.
Bank stocks’ dividend yields are competitive with, and in some cases exceed, the S&P 500. Morgan Stanley now yields 3.2%, while Bank of America and Citigroup provide dividend yields of 2.3% and 1.5%, respectively. These yields compare well with the 2% yield offered by the S&P 500 as a whole.