Given the sell-off in the sector this year, a number of super-regional banks have suddenly seen their dividend yields shoot up.
One of those is U.S. Bancorp (USB 0.32%), which now has an annual dividend yield of 5.7%. When dividends rise suddenly, they can often be a warning sign that something might be wrong with the company, but here's how U.S. Bancorp can afford to pay this large dividend.
Building capital organically
Banks have to hold regulatory capital so they can absorb unexpected loan losses and continue to lend during a severe economic downturn. One key regulatory capital ratio is the common equity tier 1 capital ratio, which looks at a bank's core capital expressed as a percentage of its risk-weighted assets (RWA), such as loans.
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The largest and most complex banks in the country have a CET1 requirement each year set by the Fed, and U.S. Bancorp's current CET1 requirement is 7%. Excess capital above this threshold can be used to return capital to shareholders, although banks typically keep an internal buffer as well. At the end of the first quarter of this year, U.S. Bancorp had a CET1 ratio of 8.5%.
Each quarter's worth of dividends at U.S. Bancorp currently costs the bank about $735 million, or 0.59% of RWA ($0.48 dividend x 1.53B shares/$493.3B RWA). But remember, U.S. Bancorp is also typically generating $1.4 billion to $1.6 billion of net income per quarter, which it can use in part to cover the dividend. Analysts also currently expect 2023 earnings to be well above last year's earnings, not that estimates couldn't change after second-quarter earnings results.
While the dividend looks well covered, investors have had concerns about U.S. Bancorp's capital levels, which fell below peers after the bank acquired Union Bank. U.S. Bancorp is also sitting on billions of unrealized bond losses after investing liquidity into bonds too early in the interest rate cycle. Those bonds, which have an inverse relationship with bond yields, are now deeply underwater.
Currently, these unrealized paper losses are not factored into the bank's CET1 ratio. But after everything that happened in the banking crisis earlier this year, regulators are contemplating requiring super-regional banks like U.S. Bancorp to incorporate a portion of those unrealized losses into their CET1 ratios. If that were to happen, then U.S. Bancorp would see its CET1 capital ratio fall below its 7% requirement, at which point it might need to consider cutting the dividend. However, I suspect the Fed, if it does implement this rule, will provide banks with a phase-in period.
U.S. Bancorp also got another dose of good news for its dividend when the Fed released its annual stress-testing results. The Fed conducts this exercise by trying to simulate how the largest and most complex banks and their balance sheets would hold up in a severe recession. Stress testing also helps determine CET1 requirements. Not only did all banks pass this year's stress-testing exercise with flying colors, but it looks like U.S. Bancorp's CET1 requirement will stay at 7% for next year.
The dividend should be safe
U.S. Bancorp's dividend does not come without some risk. Earnings could take a big hit in the second quarter, as banks report a full quarter after the banking crisis that will most certainly be categorized by much higher funding costs, which will cut into bank margins.
However, U.S. Bancorp should hopefully begin to see unrealized bond losses start to taper off over the next quarter or two as the duration of its bond portfolio gets shorter. Unrealized bond losses are recouped as long as U.S. Bancorp doesn't have to sell them.
Additionally, the positive results from stress testing will keep U.S. Bancorp's CET1 requirement manageable, and the bank's increased earnings power from the Union Bank acquisition is expected to help the bank accrete capital toward a 9% CET1 ratio later this year. I also expect regulators to give banks time to make adjustments if they do eventually require banks to incorporate some of their unrealized bond losses into their CET1 ratios.
Given all of this, I think U.S. Bancorp can continue to cover its current 5.7% dividend yield. Hopefully, the stock will start to rebound as well as some of these capital concerns are alleviated and investors get better visibility into bank earnings amid the difficult funding environment.
