When Bank of America (NYSE:BAC) announced last Monday that it would halve its dividend, the market wasn't impressed. But B of A is just the most prominent name among a long list of financials doing the same thing. In the third quarter, with dividends hitting historic lows, financials accounted for over 90% of the $22.5 billion in dividend cuts, according to Standard & Poor's. What's a dividend-focused investor to do?

If you've suffered a cut on some of the bank stocks you own, that's painful. If that hasn't happened to you yet, you should know that it soon might. For banks, bending over backward to maintain their dividends defies rationality in the current environment -- in the long run, that attitude is difficult to sustain.

The hardest cut may be necessary
The banking sector appears to be in denial concerning the irrationality of maintaining dividends at current levels. According to Standard & Poor's, the sector is set to make $50 billion in dividend payments this year -- the largest of any sector. Leveraged at 12:1, that sum would support $600 billion in bank assets or new bank loans. That's hardly chicken feed!

By my rough estimate (which assumes their share counts and dividends remain constant with respect to the last quarter), the five largest banks alone are set to pay out nearly $25 billion in dividends over the next 12 months. Those banks are JPMorgan Chase (NYSE:JPM), Bank of America, Citigroup, Wells Fargo (NYSE:WFC), and US Bancorp (NYSE:USB).

(In case you're wondering, that estimate takes into account Bank of America's announced dividend cut.)

Raising capital from Peter to pay Paul's dividend
Here's more evidence of the absurdity of the banks' collective behavior in this area. In a report published by Goldman Sachs (NYSE:GS) in June, analysts estimated that U.S. banks might need to raise $65 billion in additional capital. In other words, if banks had eliminated their dividends this year, the savings would have made up more than three-quarters of the present shortfall in capital.

What many banks are effectively doing is funding dividend payouts to shareholders with dilutive share offerings or other expensive forms of equity financing (such as higher-yielding preferred shares). That approach to capital management just doesn't make sense, as it destroys shareholder value.

Sorting through the usual suspects
So who'll be next to bite the bullet and reduce their dividend? In order to identify likely candidates, I looked for banks that are in the top quintile with respect to dividend yield and in the bottom quintile for Tier 1 Capital ratio. The Tier 1 Capital ratio is a measure of capital adequacy (I discuss this in more detail below), while a high dividend yield can be the market's signal that it expects the company to cut its dividend.

The screen produced 13 names; the following table displays the five largest by market value -- note that they happen to be among the top 30 banks in the U.S. by the same measure, with two in the top 10.

Bank

Dividend Yield

Tier 1 Capital Ratio

Comments

Bank of America

8.0%

8.3%

The screen was predictive in this case: B of A announced its dividend will be cut in half.

BB&T (NYSE:BBT)

5.3%

8.9%

--

SunTrust Banks (NYSE:STI)

6.2%

7.5%

No plan to alter dividend policy, according to Sept. 9 regulatory filing

KeyCorp

6.4%

8.5%

--

Marshall & Ilsley

6.0%

7.9%

--

Tier 1 Capital is equal to shareholders' equity, from which one deducts goodwill, other intangible assets and deferred tax assets. The Tier 1 Capital ratio (Tier 1 Capital / Total Assets) is a measure of the extent to which a bank has leveraged its equity capital. A higher ratio indicates lower leverage (there is more equity to support each dollar of assets on the balance sheet), and, thus, lower total risk.

The Federal Reserve has set 3% as the absolute floor for the Tier 1 Capital ratio. Note that the average Tier Capital 1 Ratio for publicly traded U.S. banks is 12% and the median is 10.5%. The five banks in our table fall significantly short of those figures. (However, all of them are comfortably clear of the 5% hurdle that banking regulators set for the lowest risk category of banks.)

Still, two metrics don't tell the whole story, and the banks in the above table aren't a homogeneous set. Consider that the percentage of nonperforming loans ranges between 1.1% and 2.2%. The range of net charge-offs as a percentage of total loans is even wider: 0.7% to 3.3%.

All dividends aren't created equal
I'd sort the five banks into two groups: KeyCorp, SunTrust Banks, and Marshall & Ilsley are what I'd consider to be "dividend at risk" stocks; BB&T and B of A ( post-dividend cut announcement), on the other hand, are "safe dividend" stocks.

If you own one of the stocks in the first group, don't be alarmed; my cursory analysis could certainly be wrong. However, if the dividend is a major reason you invested in these banks, I'd suggest looking more closely at them to determine the safety of their dividend. Also, if you own BB&T or B of A, don't assume you're entirely safe.

The prudent course of action for many banks right now would be to reduce or eliminate their dividends. Keep in mind that maintaining the dividend can destroy shareholder value. That is, after all, the only criteria worth considering when analyzing the merits of a bank management's decision to maintain or cut its dividend.

More credit crisis Foolishness:

All dividends aren't created equal. Perhaps it's no coincidence that three banks that are riding out the current crisis better than their peers -- JPMorgan Chase, BB&T and US Bancorp -- have been Motley Fool Income Investor recommendations since well before the crisis began. To find out the latest recommendations, take a 30-day free trial today.

Alex Dumortier, CFA, has a beneficial interest in BB&T and Wells Fargo, but not in any of the other companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.