Most large banks say they will maintain their normal dividends in the third quarter, but as suspected, Wells Fargo (NYSE:WFC) expects to have to reduce its dividend from its current level of $0.51 per common share. The company said in a press release that the third quarter dividend amount will be released on July 14. Other large banks in the U.S., including JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C), Morgan Stanley (NYSE:MS), and Goldman Sachs (NYSE:GS), all said they will continue to distribute dividends at their current levels in the third quarter.

Wells Fargo building

Image source: Getty Images.

Why Wells Fargo?

Last week, the Federal Reserve released the initial results of its annual bank stress tests. During this exercise, the Fed puts banks through various hypothetical adverse economic scenarios to see if their regulatory capital can withstand economic downturns of different degrees. The Fed tested 33 banks, each with more than $100 billion in assets.

The Fed also ran an additional analysis to see how banks' balance sheets would hold up in economic scenarios caused by the coronavirus pandemic, such as a V-shaped or W-shaped recovery. The testing showed that while banks were well capitalized in all of the scenarios the Fed projected, some came very close to breaching their required minimum capital thresholds in the most severe of scenarios.

As a result, the Fed said banks could not increase dividends from the second quarter and that dividend payouts would be limited to the average of the firm's net income for the four preceding calendar quarters.

That immediately became problematic for Wells Fargo, because the bank is currently under an asset cap from the Fed that prevents it from exceeding roughly $1.95 trillion in total assets. Since the bank is right up against the cap, it is very difficult for it to increase profits. Additionally, last quarter the bank was forced to set aside billions to cover future expected loan losses brought on by the pandemic.

The bank only generated $0.01 in earnings per share in the first quarter and is not expected to do much better in the second quarter. That will significantly limit its four-quarter average of profits, making it difficult to sustain its current dividend with the Fed's new restrictions.

Goldman Sachs is a big indicator

The fact that Goldman Sachs is able to maintain its normal dividend could bode well for the rest of the banking industry, at least as it pertains to dividends in the third quarter. 

The Fed's stress testing results showed that Goldman's common equity tier 1 (CET1) capital ratio fell to the lower end of its peers in a hypothetical severely adverse scenario set up by the Fed. The CET1 ratio is the base level of capital a bank needs to maintain so that even after accounting for lots of unexpected loan losses, it can still continue to extend credit to people and businesses during a downturn. This ratio must stay above 4.5% of risk-weighted assets at a bank.

During the severely adverse economic scenario, which is actually a scenario that could happen because of how unprecedented the coronavirus is, Goldman's CET1 ratio fell to 6.9%. It wasn't the lowest of all banks tested, but it was definitely toward the bottom quartile. This suggests that most of the big U.S. banks should be able to maintain their current dividends, although some banks' dividend plans for the third quarter were still unknown as of this writing.

The dividend story will continue

Being able to maintain their dividends after what is expected to be a difficult second quarter of earnings is a big achievement for many of these banks, and definitely a good sign for their stocks. However, banks will need to go through more stress testing and update their capital plans later this year due to how fast conditions are changing. The Fed could also change its dividend restrictions if economic conditions warrant down the line.

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.