As investors wonder whether banks will be able to keep paying their dividends during the COVID-19 pandemic, JPMorgan Chase (NYSE:JPM) CEO Jamie Dimon has maintained that dividends are a "drop in the bucket" relative to his bank's total capital. In other words, JPMorgan is unlikely to cut its dividend unless its capital falls below regulatory minimums and it's forced to.

But this could actually happen after the Federal Reserve releases results of this year's bank stress tests on June 25. Under the Dodd-Frank Act legislation for banks following the Great Recession, the Federal Reserve puts bank holding companies through various economic scenarios each year to determine whether they could maintain adequate capital if a severe recession were to occur. The tests also influence a bank's capital distribution plans, including share repurchases and dividends, because the Fed wants to ensure that a bank's capital distributions do not push bank capital levels below certain regulatory thresholds in an adverse scenario.

Let's take a look at how stress-test results could potentially force JPMorgan to cut its dividend.

JPMorgan Chase.

Image source: Getty Images.

How the testing works

It's a complicated process, but basically the Fed runs a series of projections to test a bank's resilience under various economic scenarios. In the case of a severely adverse scenario, the Fed projects how a bank's balance sheet, including its loan losses and net income, would respond in an environment where GDP contracts and unemployment rises by a significant amount, along with the deterioration of other macroeconomic measures.

The Fed does this because regulatory capital is what a bank uses to cover unexpected loan losses, which are one of the main factors that can lead to a bank's demise. So the Fed is looking to see that a bank will have enough capital in an unexpected and harsh economic downturn.

An important regulatory ratio that regulators scrutinize in the tests is the common equity tier 1 (CET1) capital ratio, which measures a bank's core capital against its risk-weighted assets. Specifically, the Fed wants to make sure that in a severe economic downturn, a bank can maintain a bare-bones CET1 ratio of 4.5%. This is hypothetical, of course, and the Fed hopes a bank never actually finds itself in this situation. But stress tests also play a part in determining the actual CET1 ratio that banks must maintain so that in an unlikely event, banks can make their capital distributions, survive lots of unexpected loan losses, and still stay above the 4.5% threshold.

Here is how JPMorgan's required CET1 ratio was calculated last year:

JPMorgan Chase 2019 CET1 Requirements

Image Source: JPMorgan Chase.

As you can see, JPMorgan's required CET1 ratio was 10.5%, broken down into three different layers.

  • Every bank has the base 4.5% minimum requirement.

  • Then there is the middle layer, called the capital conservation buffer. This section has actually been replaced this year with the stress capital buffer (SCB), which is calculated differently but will add at least 2.5% of the CET1 ratio. Similar to the capital conservation buffer shown above, the SCB is intended to absorb losses in times of economic stress.

  • Lastly, a select group of the largest banks in the U.S. have a global systemically important banks (GSIB) surcharge. The Fed requires the largest banks in the country -- JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo, along with a few others -- to hold more capital than others because if one of these banks fail, it could bring down the entire financial system. The GSIB surcharge varies from bank to bank, but JPMorgan said in its most recent annual filing that its GSIB surcharge would be 3.5% in 2020.

How the Fed could force a dividend cut

The CET1 ratio can move up or down with the stress-testing results, which are based on macro assumptions. The problem this year is the coronavirus pandemic has thrown the Federal Reserve for a loop. In February, before the virus really hit the economy, the Fed released the macro assumptions it would use for the adverse scenario in its stress testing. The Fed said that in this hypothetical scenario, U.S. unemployment would rise to a peak of 10% by the third quarter of 2021, while GDP would fall about 8.5% from its pre-recession peak. The Fed's stress tests forecast out over a nine-quarter period.

As the pandemic took hold, that scenario proved not so hypothetical. On June 10, the Fed said it expected actual unemployment to rise to 9.2% and actual GDP to contract 6.5% by the end of 2020. Because of the severity in the actual economy, the Fed said it will also include additional analysis of how the coronavirus's impact on the economy could affect bank capital in this year's stress testing.

The Fed has the ability to increase the amount of regulatory capital banks must hold by effectively increasing the SCB, which absorbs losses in times of financial stress. We can assume the base minimum CET1 requirement will remain at 4.5% and that JPMorgan's GSIB surcharge will remain at 3.5%. 

Federal Reserve New SCB Requirement

Image source: Federal Reserve.

As you can see above, the SCB must be at least 2.5%. However, this middle layer is calculated by adding the bank's expected dividends over four quarters along with projected stress-test losses in an adverse scenario. The Fed may increase projected stress-test losses because macro assumptions could get a lot worse than anyone ever anticipated in reality or in a hypothetical scenario. 

A recent research note from the bank research firm Keefe, Bruyette & Woods (KBW) says that if the Fed were to increase JPMorgan's projected provision expenses (cash set aside to cover loan losses) by 40% from last year in its analysis, JPMorgan's new CET1 ratio regulatory requirement would grow to 12.25%. That would be problematic for the banking giant because at the end of the first quarter of the year, its actual CET1 ratio was 11.5%. This number could come up during the year, but KBW does not expect it to get higher than 12.25%, meaning the bank's CET1 ratio would fall below regulatory requirements.

Perhaps the Fed will grant some banks that dip slightly below their regulatory requirements some kind of break given these unprecedented circumstances. But normally, banks that fall below the CET1 requirement are limited to capital distributions of 60% of eligible retained income (ERI). Eligible retained income is defined as the average of the preceding four quarters of net income.

Lots of banks already keep their dividend payments under 60% of ERI, and most banks being stress-tested have suspended share repurchases. But according to KBW's projections, if JPMorgan's CET1 ratio did fall below the required ratio, even with suspending share repurchases, dividends could make up more than 70% of ERI by the fourth quarter of this year, meaning some kind of dividend cut would likely be required.

How likely is this to happen?

Nobody knows the assumptions the Fed will use when conducting its coronavirus analysis. On one hand, the Fed's severely adverse scenario is supposed to be a hypothetical event that plans for the worst. On the other hand, what has happened to the economy thus far because of the pandemic already seems to be an unprecedented event.

If you look at JPMorgan's stress-testing results from last year, the bank projected credit provisions of $43 billion over a nine-quarter period in a severely adverse scenario, where the Fed assumed GDP contracting by 5.9% and unemployment peaking at 8.9%. In the first quarter of this year, JPMorgan had a roughly $8.3 billion credit provision. Dimon said at a recent conference that the provision in the second quarter could be just as large, putting the combined provision over the first two quarters of the year at more than $16 billion. That's already more than a third of the provision under last year's adverse scenario, and the economy is expected to be in a worse situation by the end of 2020 than the assumptions used under the 2019 stress-test adverse scenario.

Because conditions have already gotten so severe, it would not surprise me to see the Fed significantly raise the hypothetical provision for banks in their additional analysis, which would raise the bar for the CET1 ratio requirements. Ultimately, I don't think stress testing results will force a ton of banks to cut their dividends, but a few of the bigger banks could be at risk, which could have a domino effect.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.