Bank of America (BAC 1.49%), America's second largest bank by assets, has thus far held up a lot better during the coronavirus pandemic than it did during the Great Recession. CEO Brian Moynihan has built Bank of America into a much stronger and safer bank over the last decade. Not only is the balance sheet much less risky, but Bank of America currently has more capital than it knows what to do with.
If regulators remove certain restrictions later this year, the bank will likely be able to go on the offensive and authorize a large amount of capital for share repurchases. Here's why.
So much capital
Simply put, Bank of America has more than $176 billion of common equity. If you add less liquid forms of capital the bank has to this amount, the bank has total capital of more than $227 billion, although the $176 billion is a better number to focus on. Banks can use this common equity to pay dividends, conduct stock buybacks, grow the bank organically, invest in its operations, or do a merger or acquisition.
Image source: Bank of America.
However, not all of this capital is actually in play because banks are required by their regulators to retain a certain amount of capital so they can absorb unexpected loan losses and still be able to lend to individuals, families, and businesses during an economic downturn. There are many capital ratios banks must abide by, but a big one is the common equity tier 1 (CET1) capital ratio, which measures a bank's common equity as a percentage of its risk-weighted assets.
So, if you divide the roughly $176.7 billion in common equity by the bank's $1.48 trillion in risk-weighted assets, you get a CET1 ratio of 11.9%. However, regulators only require Bank of America to maintain a CET1 ratio of 9.5%, meaning the bank had a whopping $36 billion over this requirement at the end of 2020. And one thing to understand is that a good chunk of earnings each quarter funnel into common equity, so it's not like the $36 billion only runs down.
Another thing to point out is that Bank of America will not be restrained by any other capital ratios. For instance, because bank balance sheets have ballooned due to the influx of deposits into the system, some large banks could soon run into trouble on their supplementary ratio, a measure of a bank's tier 1 capital divided by total leverage exposure. But as Moynihan said on the bank's recent earnings call, the supplementary leverage ratio will not be an issue for Bank of America.
What to do with all of the capital
As I mentioned above, there is a lot a bank can do with the excess capital. But Bank of America is actually more limited in its options than one might think. It can't make any depository acquisitions to enter new markets because it already owns more than 10% of U.S. deposits, and regulators do not allow any one bank to cross that threshold.
The bank will continue growing organically in new markets, efforts that have been successful, and CFO Paul Donofrio said the bank is also investing $3.5 billion in technology this year. But Bank of America can likely earn that amount back in just one quarter, because remember earnings to some extent replenish common equity.
So, one of the best moves the bank can really make is to return capital to shareholders through share repurchases. Currently, regulators are limiting capital distributions, including dividends and share repurchases, to no more than the trailing four-quarter average of net income. That will allow Bank of America to repurchase up to $3.2 billion worth of shares through the first quarter of this year.
However, as the economic outlook improves this year, banks are hopeful the Federal Reserve might remove these limitations and allow banks to do what they want as long as they stay above their required regulatory capital ratios. If this happens, Moynihan (on the bank's most recent earnings call) made every indication that share repurchases would accelerate. "Now, we're looking to return as much capital for our shareholders as we're allowed and as our board deems prudent," he said.
Watch the Fed
With so much excess capital, a better year of profitability ahead, and not many options for how to put that capital to work, I would expect Bank of America to repurchase as many shares as it can. The Fed has limitations in place, so be sure to watch if it lifts those in the second or third quarter of the year. If it does, expect Bank of America to take full advantage.
