If you invest in banks, you probably already know that the Federal Reserve releases the results of the 2013 stress tests tomorrow. As I discussed earlier today when noting that Bank of America (NYSE:BAC) will likely pass the test with flying colors, how banks perform during this stage in their annual regulatory cycle largely dictates whether or not they'll be able to increase the amount of capital they return to shareholders via dividends and/or share buybacks for the remainder of the year. This is why the stress tests are so important.
That being said, with respect to at least some banks, the term "stress test" is a bit of a misnomer. In other words, there's little question that certain banks will sail through the process without anything to worry about. If the title of this article didn't already give it away, Wells Fargo (NYSE:WFC), the nation's fourth largest bank by assets, is one such bank.
A brief introduction to stress tests
As I discussed earlier:
In the wake of the financial crisis, Congress enacted the Dodd-Frank Act, which requires the Federal Reserve to conduct stress tests of banks and other financial concerns with assets in excess of $50 billion. The purpose is to evaluate whether these so-called too-big-to-fail institutions have, as the Fed describes it, "sufficient capital, on a total consolidated basis, to absorb losses as a result of adverse economic conditions."
The process seeks to simulate the impact on a bank's regulatory capital levels under three hypothetical and increasingly severe economic scenarios. The most arduous assumes that real GDP declines an average of 4% this year, the unemployment rate ticks up to 12.1% in the second quarter of next year, and that home prices fall by more than 20% by the end of 2014. Suffice it to say, this is an extreme case. As the Fed notes, at least with respect to unemployment, the designated rate remains "above any level experienced over the last 70 years" -- that is, since the Great Depression.
When subjected to a similar set of assumptions last year, the vast majority of banks passed the test with ease. In Wells Fargo's case, its Tier 1 common capital ratio fell from 9.34% of risk-weighted assets down to 6.6%, well in excess of the required 5% rate. As you can see here, this placed it in the middle of its peer group, or 8th out of the 19 banks tested. While it was the best-performing of the four so-called too-big-to-fail banks, it was beaten out by American Express, the custodial banks State Street and Bank of New York Mellon, and a smattering of regional lenders including Fifth Third Bancorp (NASDAQ:FITB), U.S. Bancorp (NYSE:USB), and BB&T (NYSE:BBT). The latter three, for instance, ended up with Tier 1 common capital ratios of 7.7%, 7.7%, and 7.3%, respectively.
Given that Wells Fargo's capital levels have since increased, it seems safe to assume that it'll sail past the tests this year even more comfortably. At the end of the third quarter in 2011, its Basel I Tier 1 common capital ratio was 9.34%. By the end of the third quarter last year, this had grown to 9.92%. And as you can see below, it has copious amounts of excess capital regardless of how you measure it.
What this chart shows us is that Wells Fargo has between $52.4 billion and $58.7 billion in capital beyond regulatory minimums depending on which capital ratio is employed. For instance, it has nearly double the amount of Tier 1 common capital than required under the prevailing regulatory scheme -- that is, it holds $52.4 billion of capital beyond the minimum $53.4 billion required.
In addition to its static capital levels, moreover, Wells Fargo has the capacity to accumulate cash in a short period of time. Despite paying out roughly a third of its net income via dividends and buying back a considerable amount of stock last year, its retained earnings nevertheless grew by 21% from the third quarter of 2011 to the third quarter of 2012. Also, the bank is earning more money than it ever has. Last year, it reported almost $19 billion in net income. That's more than twice its record before the crisis!
Taken together, in turn, it seems highly unlikely that Wells Fargo would run into any problems passing this round of stress tests. Consequently, the more interesting question will be if, and how much, it increases its dividend when presumably given the approval to do so next week.