Why Aren't Banks Justified in Boosting Dividend Payouts?

With the Federal Reserve finally giving its consent for big banks to increase dividend payments, everyone is heaving a sigh of relief … well, almost everyone.

Credit rating agency Standard & Poor's seems to have different ideas.

The immediate results
With several big banks coming up with plans to raise their dividends and buy back stock, it seems that the financial crisis is firmly a thing of the past. Economic recovery aided by strong operating profits in the financial sector has no doubt helped the big banks pass the dividend stress tests.

Let's put things into perspective. According to revisions in the GDP last week, the finance sector accounts for 30% of all fourth-quarter operating profits for 2010. Considering the recency of the financial crisis, this is definitely a positive thing for the banks, especially because this sector contributes less than 10% to the overall GDP.

In absolute numbers, finance profits jumped to $426.5 billion. It's agreed that the financial sector led the way into the recession, but now the same sector is leading the way out. Shouldn't they now be entitled to return capital to shareholders?

Not according to credit rating agency S&P. The reason: The economic crisis is not fully over and banks still don't have the balance sheet strength to afford returning capital to shareholders. The agency said that banks need an 8% risk-adjusted capital ratio to make sure that another financial crisis is avoided, and it argues that banks still fall short of the target on an average which read 7.6% at the end of 2010.

The performance
So how exactly are the banks placed? The big banks have definitely recovered. Let's have a look at their capital ratios individually.

According to Basel III norms -- the new global standards set following the financial crisis for adequacy in bank capital requirements, liquidity, and leverage -- the minimum tier 1 capital ratio must be 6% and total capital ratio 8%.

Bank of America's (NYSE: BAC  ) tier 1 capital ratio stands at 11.2%, while the total capital ratio is 15.8%. This is not bad. However, the Fed recently blocked its move to increase dividends later this year. This might be because of the bank's huge mortgage business, which is still under particular scrutiny from institutional investors and state attorneys general. Fair enough.

JPMorgan Chase (NYSE: JPM  ) has a tier 1 capital ratio of 12.1% and a total capital ratio of 15.5%. With approval from the Fed, the bank is raising its quarterly dividend to $0.25 a share from $0.05. It also plans to buy back stock worth $15 billion. This bank is behaving like the crisis is almost fully behind it.

Citigroup (NYSE: C  ) has a tier 1 capital ratio of 12.9% and a total capital ratio of 16.6%. The Fed approved its plan to get back to its $0.01 per-share dividend.

Capital One's (NYSE: COF  ) tier 1 capital ratio stands at 11.6%, while the total ratio is 16.8%. The bank has not disclosed the Fed's response on its capital plan, though it will not be raising its dividend this quarter. However, it has managed to dramatically reduce its year-over-year leverage ratio to 8.1%, from 10.3% at the end of 2009, as well as its total asset-to-total equity to a very low 7.4.

Goldman Sachs (NYSE: GS  ) holds a tier 1 capital ratio of 16%, while the total capital ratio stands at 19.1%. Traditionally, investment banks such as Goldman Sachs and Morgan Stanley are supposed to keep higher capital levels since their assets tend to be riskier. The Fed approved the bank's payback of $5.65 billion to Warren Buffett, including the 10% premium, which it borrowed during the financial crisis.

Morgan Stanley (NYSE: MS  ) has a tier 1 capital ratio of 16.6% and a total capital ratio of 16.5%. Another bank yet to reveal the Fed's response, it says it will find profitable ways to use its excess capital, which means it might reinvest it in the business or buy back stock.

What next?
Is S&P justified in issuing warnings that at "this juncture of economic recovery," excessive payouts to investors might hinder capital requirements? Probably yes. It seems the agency, along with Moody's and Fitch (the three major ratings agencies), is particular about not repeating the mistakes, as they were all completely in the dark on the financial collapse in 2008.

My attitude is that S&P is more concerned about stock buybacks and special dividends which might reduce capital levels. That position is justified, despite the fact that these big banks collected substantial profits, because that won't continue forever.

Someone must address the huge leverage big banks employ, as this happens to be one of the primary causes of the downturn. The problem lies with the fact that certain banks take it for granted that they are "too big to fail" and believe a government bailout will always be around. Their claims that capital levels are adequate should therefore be treated critically. There is no harm in being cautious when high unemployment, government cutbacks, and rising oil prices all pose risks to the U.S. economy.

Isac Simon does not own shares of any of the companies mentioned in this article. The Fool owns shares of Bank of America and JPMorgan Chase. Through a separate Rising Star portfolio, The Fool is also short Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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