Large banks like JPMorgan Chase and Citigroup had to pause share repurchases earlier this year in light of higher regulatory capital requirements that will come into play in 2023 and 2024. Meanwhile, Wells Fargo (WFC 2.74%) has plenty of capital but put off repurchases due to the uncertain economic outlook and market volatility. That makes Bank of America (BAC 3.35%) the only bank in its peer group that not only repurchased shares in the third quarter of the year, but also will continue to be able to do so for the remainder of the year.
The bank has gotten into this position by managing capital extremely well, despite a difficult environment. Let me explain.
Rising regulatory capital requirements
Banks are required by regulators to set aside a large amount of capital to be prepared for unexpected losses should the economy suddenly take a turn for the worse. Although banks have many capital ratios they must maintain, a key one to watch is called the common equity tier 1 (CET1) capital ratio, which is a measure of a bank's core capital, expressed as a percentage of its risk-weighted assets (RWA) such as loans.
These ratios tend to fluctuate quarter to quarter because banks deplete them when they use capital to make an acquisition, buy back shares, or pay dividends. They also need to set aside capital when they make new loans to account for potential future loan losses. However, capital is also replenished by earnings each quarter.
Regulators determine a bank's required CET1 ratio by the size and riskiness of the bank, and then management teams usually like to keep a little buffer over that required level. Excess capital above management's internal target can be used for the activities mentioned above, such as repurchases or dividends.
Many large banks faced higher requirements starting in the fourth quarter of this year and could also face higher regulatory requirements in 2023 and 2024 (unless regulatory capital rules change), which means most of them have to build capital. This leaves very little excess capital available for repurchases right now. Bank of America's required CET1 ratio jumped from 9.5% to 10.4% this year, so the bank has also been building capital.
A fast capital build
Bank of America managed to increase its CET1 ratio very quickly, from 10.5% in the second quarter to 11% at the end of the third quarter, comfortably over its new requirement. Remember, Bank of America has trillions of dollars of assets, so the move in these ratios may look small -- but we're talking about billions of dollars over one quarter.
Another thing to understand is that the CET1 ratio is composed of both a numerator and a denominator, so a bank can increase the ratio by building CET1 capital or decreasing RWA. In the third quarter, Bank of America grew CET1 capital by $4 billion, while reducing its RWA by $39 billion.
What's impressive is that the bank managed to build capital while repurchasing more than $400 million of stock during the third quarter. What helped the most was the $6.6 billion in net income that Bank of America generated in Q3 and the reduction of RWA.
Bank of America's Chief Financial Officer Alastair Borthwick said the bank managed to reduce RWA largely by selling some loans and reinvesting proceeds from its bond portfolio into bonds that carry less of a risk weighting
Banks have to set aside a different amount of capital for different kinds of assets they bring on the balance sheet, based on riskiness. For instance, a bank would have to set aside more capital for a construction loan than a U.S. Treasury bond because there's a much higher chance of losses in a construction loan.
The new bonds in which Bank of America is reinvesting likely carry a lower risk weighting. They also carry a higher yield now, given the rate environment, which can help with regulatory capital, as well, because these bonds generate more earnings that replenish capital.
Standing out among its peers
Strong capital management by Bank of America has enabled the bank to continue repurchasing shares while its three main competitors have paused them. Furthermore, Chief Executive Officer Brian Moynihan said on the bank's earnings call that shareholders can expect to see repurchases increase.
I don't think you'll see JPMorgan Chase, Citigroup, or Wells Fargo buy back any stock this year, even though Wells Fargo could if it wanted.
The continuation and likely increase of share buybacks is a nice way for Bank of America to separate itself from the pack. Plus, share repurchases made when the bank is trading at a lower valuation after a difficult year are more beneficial.
