During the financial meltdown, many banks cut their dividends in order to bank capital. The biggest of the Too Big To Fail gang have now left TARP, and many have rebuilt their funds enough to start returning money to shareholders with dividends or share buybacks.

Last November, the Federal Reserve issued guidelines for bank proposals to increase dividends or buy shares. The key points are surviving another recession and meeting regulatory capital requirements. The guidance included the following note:

In general, the Federal Reserve expects that plans submitted in 2011 will reflect conservative dividend payout ratios and net share repurchase programs (i.e., requests that imply dividend payout ratios above 30% of after-tax net income will receive particularly close scrutiny).

In other words, investors shouldn't bank on fat dividend checks or monster share buyback programs.

We don't know details of the Fed's evaluation process, but we can compare banks' capital ratios at the end of 2009, after they had completed raising capital for the stress tests, to ratios at the end of 2010. The Tier 1 capital ratio represents Tier 1 capital -- common and preferred stock, retained earnings and reserves -- divided by the bank's assets. The Tier 1 common ratio is similar, but it excludes preferred stock and a few other items. Both ratios measure a bank's ability to hold up in bad times. Regulators define "Well Capitalized" as more than a 6% Tier 1 Capital ratio, but as the recent meltdown showed, that bar isn't always high enough.

The table below shows the Tier 1 capital and common ratios for the five largest bank holding companies by assets:

Bank

Tier 1 Capital Ratio
(Dec '09)

Tier 1 Capital Ratio
(Dec '10)

Tier 1 Common Ratio
(Dec '09)

Tier 1 Common Ratio
(Dec '10)

Bank of America (NYSE: BAC)

10.4%

11.2%

7.8%

8.6%
JP Morgan Chase (NYSE: JPM)

11.1%

12.1%

8.8%

9.8%
Citigroup (NYSE: C)

11.7%

12.9%

9.6%

10.7%
Wells Fargo (NYSE: WFC)

9.3%

11.3%

6.5%

8.4%
Goldman Sachs (NYSE: GS)

15%

16%

12.2%

13.3%

*Source: Company 2009 and 2010 earning reports.

All five banks have increased capital ratios over the past year. That isn't surprising, given bank earnings over the past year and stabilization in the financial sector. Fed regulators will consider asset risk and other factors in addition to capital ratios in their evaluations. One factor that wasn't part of the 2009 stress tests will be banks' plans to comply with Basel III capital requirements.

Unless there are new wrinkles to stress testing, or Basel III has added capital requirements well beyond the '09 stress tests, all five of these banks appear to be well-positioned for dividend hikes or share buybacks. The highest potential for downside surprises resides with Wells Fargo and Bank of America. There isn't much cushion between reported Tier 1 common ratios and the 7% target for Basel III, although both banks exceed that target. However, with capital ratios second only to Goldman Sachs, there's potential for Citigroup to surprise and start buybacks or a dividend.

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