(By Mani) On Friday, the Fed released its guidelines for its annual stress test for the top 19 banks (ie CCAR) and the 11 next largest banks (CapPR). Banks are allowed to resubmit based on initial Fed comments, and this increases the scope for banks to ask for more capital deployment and reduces the risk that a bank "fails."
In addition, the soft cap on dividends remains 30 percent and trading assets seem likely to be more aggressively stressed given a second more adverse scenario as part of this year's process.
"Prior to Friday's release of guidelines, we had expected much higher payout ratios at the Large Cap Regionals (about 60 percent on average) vs. the Market Sensitive Banks (25-30 percent)," Deutsche Bank analyst Matt O'Connor said in a client note.
The latest guidelines reflect a more aggressive stress testing of trading assets, more volatile earnings streams of market sensitive banks and lower Basel 3 capital levels.
"In general, we still have this view although believe payout ratios could be slightly higher across the board than we previously assumed (given the ability to resubmit)," O'Connor said.
Of the banks that are part of Comprehensive Capital Analysis and Review (CCAR), yields could be 3.5 percent to 4 percent at BB&T Corp. (NYSE:BBT), Fifth Third Bancorp (NASDAQ:FITB), PNC Financial Services Group Inc. (NYSE:PNC), and Wells Fargo & Co. (NYSE:WFC).
"FITB could have the highest yield at 4 percent, assuming a payout ratio of about 35 percent. All of these banks have diversified business models, have been above average risk managers in our view," O'Connor noted.
The above banks have solid (or better) underlying earnings power and with the exception of PNC have had only modest EPS volatility in recent years, suggesting that the Fed may be more open to these banks having dividend payout ratios slightly above 30 percent.
Despite the 30 percent dividend payout ratio soft cap, banks should push for slightly higher payout ratios, maybe 35 percent. This reflects the very low interest rate environment and the related search for yield among many investors globally, sluggish prospects for organic revenue and EPS growth and likely limited opportunities to make acquisitions.
"Some bank stocks currently yield 2.5 percent to 3 percent and could see yields rise to 3.5 percent to 4 percent, assuming 35 percent payout ratios. This extra yield could broaden out the investor base for certain bank stocks considering how few high yielding stocks there are in the overall S&P 500 (there are just 52 large caps in the S&P 500 that have yields of 3.5 percent or more and 34 are at 4 percent plus)," the analyst said.
Following are some of the key CCAR guidelines:
CCAR will include the 19 firms same as last year. In a change from prior years, CCAR firms will have one opportunity to make a downward adjustment to their planned capital distributions from their initial submission before a final Fed decision is made.
As was somewhat expected, the Fed will release two sets of post-stress data for each firm versus one adverse scenario last year. The Fed can object in whole or in part to a banks distribution requests.
Tier 1 common minimum is still 5 percent. A Systematically Important Financial Institution (SIFI) charge will need to be estimated by banks as well in the analysis.
Capital plans need to be submitted by Jan 7, 2013. Bank holding companies must resubmit plans within 30 days if rejected. Banks will be required to publish a summary of their stress test results under the severely adverse scenario between March 15 and March 31. The Fed will publish their results by March 31.
Banks will be provided a description of the market shock scenario by Dec.1. These banks will also need to provide details of their European exposures.
"We have thought that it would be reasonable to assume that this is more strenuous vs last year given JPM's CIO loss. The shock will cover trading books, private equity positions, and counterparty credit exposures," O'Connor said.
Projections showing compliance with Basel 3 capital levels until it fully phases in (steps up through 2018) will need to be provided, in addition to the nine quarters of projections used to determine distributions.
Some banks may already exceed Basel 3 transition targets currently, but the Fed will be looking for a plan that still shows steady accretion of capital to demonstrate continued progress towards full compliance when Basel 3 capital requirements are fully phased in to avoid the need for back-loading the capital build.