No bank left the Federal Reserve's annual stress testing a bigger winner than Capital One Financial (COF 0.66%). The credit card company's projected performance through the Fed's simulated nine-quarter stressed period improved markedly from 2020, which means the company will have lower capital requirements starting in October. As a result, Capital One is not only the big winner, but is going to have significant excess capital. Let me explain.
Stellar stress testing results
Banks are required to hold a certain amount of capital for unexpected losses. One way to see this is through a metric called the common equity tier 1 (CET1) capital ratio, a measure of a bank's core capital expressed as a percentage of risk-weighted assets such as loans. All banks must maintain a base of 4.5% and then there is a relatively new layer called the stress capital buffer (SCB).
The SCB is determined through the Federal Reserve's annual stress testing, which puts banks through a hypothetical and severely adverse economic scenario to see how their capital levels would fare. The difference between where a bank's CET1 ratio starts and the low point of the CET1 during the nine-quarter stressed period essentially determines the SCB (you also add four quarters of dividends expressed as a percentage of risk-weighted assets). During last year's stress testing, Capital One had a 5.6% SCB and an overall required CET1 ratio of 10.1%.
But in this year's test, Capital One performed much better and reduced its SCB to 2.5%, giving the company a new required CET1 ratio of 7%, which is as low as banks can go because the SCB is floored at 2.5%. At the end of the first quarter of this year, Capital One's actual CET1 ratio was 14.6%, meaning the bank is holding more than double the capital it will be required to hold come October.
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Significant excess capital
Capital One's CFO Andrew Young on the company's first-quarter earnings call said that its target for the CET1 ratio is roughly 11%. But that was obviously before Capital One just knocked down its required CET1 ratio from 10.1% to 7%. In past years, Capital One has operated with a CET1 ratio near 10%, so I am going to assume right now that is a realistic target for the company and it would still leave Capital One with a 3% cushion over the requirement.
Capital One's current 14.6% CET1 ratio is arrived at by dividing the $43.1 billion of CET1 capital the company has by its more than $295 billion of risk-weighted assets. If Capital One were to take its CET1 capital ratio down to 10%, that means that Capital One has $13.6 billion in excess capital ($43.1 billion - ($295 billion x 10%)). I am simplifying this right now because I am keeping the risk-weighted assets the same and I don't actually know if Capital One will target a 10% CET1 ratio -- it may stick to 11% -- but I think these are somewhat realistic assumptions. We already know that Capital One restored its previously cut quarterly dividend back to $0.40 per share earlier this year, and announced a $7.5 billion share repurchase plan. The bank repurchased about $500 million of stock in the first quarter.
Assuming the bank repurchases the remaining $7 billion of repurchase authorization, and pays about $1 billion in common and preferred dividends this year like it did in 2019, Capital One would still have $5.6 billion excess capital above a potential 10% CET1 ratio target. And CET1 capital is replenished each quarter with retained earnings so this excess capital likely won't be getting depleted any time soon. The other thing is that Capital One's allowance for loan losses, money set aside for potential loan losses, is still quite high from where it has been in the past. So with the economy now recovering and the credit picture having improved, the company could release some of those reserves back as profits, which then could turn into retained earnings and add to CET1 capital.
Lots of flexibility
Simply put, Capital One leaves this year's annual stress testing as the big winner because it significantly reduced its capital requirements starting in October and now has excess capital even after announcing capital return plans for shareholders. This gives Capital One a lot of flexibility.
I could see the company raising its dividend again soon because while it was able to restore its dividend after having to cut it last year, the dividend hasn't had a real increase since 2015. I could also see the company increasing share repurchases or maybe even acquiring a company if it sees the right opportunity. Capital One also now has plenty of capacity to support loan growth. Shares of Capital One are already up more than 57% this year, so perhaps investors saw this coming and it's priced in, but either way, Capital One is very well positioned to return capital to shareholders and strategically grow the business.
