Bank stocks could be in for a wild ride. Image source: iStock/Thinkstock.
As someone who's followed Bank of America (BAC -0.21%) closely for years, I can't think of a time since the financial crisis that's as jam-packed as the next three weeks with events that will dictate the direction of bank-stock prices. From the stress test results to a possible dividend increase to the vote in the United Kingdom to exit the European Union, it's fair to say that investors in the nation's second-biggest bank by assets could be in for a wild ride between now and the end of June.
Even though Bank of America has navigated through the Federal Reserve-administered stress tests every year since 2011, it's still far from a sure bet that it will emerge from the gauntlet this year unscathed -- the results are due out on June 23. We got a taste for this last year, when the Fed required Bank of America to resubmit its capital plan to address weaknesses in the bank's capital-planning processes.
Investors got a second serving of Bank of America's struggles to satisfy regulators more recently when the Fed rejected its so-called resolution plan, which directs how a bank will wind down if it finds itself on the brink of failure. The Fed said in the middle of April that Bank of America's plan, along with those of four other major U.S. banks, "was not credible or would not facilitate an orderly resolution under the U.S. Bankruptcy Code, the statutory standard established in the Dodd-Frank Wall Street Reform and Consumer Protection Act."
If Bank of America were to run into problems on this year's stress test, there's little doubt that its shares would suffer. A recent analysis by Merrill Lynch, which is a Bank of America subsidiary, showed that there's a direct relationship between a bank's stock price and its stress-test performance: Banks that do well see their stock prices rise, while banks that do poorly see their stock prices fall.
Making matters worse, if Bank of America struggles on this year's test, it probably wouldn't receive approval from the Fed to raise its dividend. Unlike Wells Fargo and JPMorgan Chase (JPM 0.06%), both of which have boosted their quarterly payouts annually over the last five years, Bank of America has been allowed to increase its dividend once given its past troubles on the stress tests. Investors will know whether or not this is the case on June 29, when the Fed releases the results of the Comprehensive Capital Analysis and Review.
Not only does a low dividend weigh on the bank's profitability, as it allows capital to build up on Bank of America's balance sheet, which, in turn, reduces its return on equity, but it also signals to investors that regulators don't have confidence in the nation's second-largest bank by assets. And in a business like banking that relies on confidence and trust, the lack thereof filters directly into a bank's valuation. This goes a long way toward explaining why Bank of America's shares continue to trade for a 40% or more discount to its book value.
June 23 is also important because it's the day that voters in the United Kingdom will vote on whether or not to stay in the European Union. Jamie Dimon, the chairman and CEO of JPMorgan Chase, was recently in England as a show of support for the status quo. If the United Kingdom were to break off from the rest of Europe, not only would it cause extreme market volatility, but JPMorgan Chase also said that it would require banks to relocate many London-based operations to the continent. Bank of America is likely in the same boat given that it also has a substantial investment-banking presence in London.
The net result would be twofold. In the first case, the heightened volatility in the markets would likely hit banks' trading revenues. This was the case in the first quarter, where Bank of America, Citigroup, and JPMorgan Chase all saw double-digit declines in trading activity as scared clients chose to stay on the sidelines to wait out the turmoil. Additionally, it's fair to assume that moving offices and thousands of employees from England to the continent wouldn't be cheap.
It remains to be seen, of course, how the vote in the United Kingdom comes out, as well as how Bank of America performs on this year's stress tests. But regardless of the outcomes, investors in the meantime would be doing themselves a favor by assuming the worst, and hoping for the best.
