In the world after the financial crisis, there is a right way and a wrong way for the nation's largest banks to increase their dividends.
On the wrong side of the equation, we have Bank of America (NYSE:BAC). Last year, the bank was forced to tuck tail and dramatically reduce its planned $5 billion dividend and share buyback plan. The reason was a miscalculation in its capital ratios related to a $60 billion portfolio of structured notes. The lack of attention to detail called into question management's ability to effectively understand, monitor, and manage the bank from top to bottom.
There are a slew of lessons to be learned from Bank of America's folly, many of which the mega bank could have learned if it would have only mimicked the approach of M&T Bank (NYSE:MTB), a regional bank doing business in the mid-Atlantic region.
A rock and a hard place for the industry
For banks today, dividends are a bit of a hot topic. On one hand, the industry is by and large returning to health after the trauma of the financial crisis. Profits have returned, capital levels are up, and banks want to return capital to shareholders.
On the flip side is the Federal Reserve's annual CCAR stress tests. For the nation's largest banks, these stress tests give the Fed the power to veto the bank's planned dividends or share buybacks if the regulator determines the bank to be undercapitalized in a hypothetical recession.
Shareholders are pushing for increases; regulators are slamming on the brakes. It's a rock and a hard place.
The right approach to bank dividends today
The key for banks today is a combination of patience and prudence, two qualities M&T exemplifies. If those two qualities don't light your fire as an investment pitch, consider that M&T is one of Warren Buffett's core holdings and that the stock has returned 43,590% in total returns since 1980.
M&T currently sports a dividend yield of 2.4%. That's nothing earth shattering, but it still beats the S&P 500's 1.99% yield.
M&T hasn't raised its dividend since 2007, in part because of the uncertainty of the financial crisis and Great Recession, but also because the bank chose to grow its capital base organically in the subsequent years. The bank didn't dilute shareholders' positions by issuing new shares, but instead relied on its profitability to steadily increase its capital base.
It was a prudent move at the time, and one that's been rewarded with a strong CCAR performance last year and a robust capital base. The bank reported a Tier 1 leverage ratio at 9.83% as of Dec. 31, which is well in excess of the required 7% to be considered "well capitalized" by regulatory standards.
While Bank of America hastily pushed out its massive dividend plan without crossing all the "t"s and dotting all the "i"s, M&T is patiently working with regulators, learning the ins and outs of the stress tests, and holding the course until regulators and investors get a strong sense of the company's risk profile in those stressed scenarios.
Patience today should help reap much greater rewards in the future.
M&T CFO Rene Jones spoke to this exact point on the company's fourth-quarter conference call this month:
I think over the course of the next couple of [CCAR] submissions, two things will happen. One, we'll get to a much more normalized [dividend] payout ratio because you will have gone through the test and you will have a lot of evidence that suggests that, not only under your models but under the national models, people have a good sense of what your risk profile is. Down that road, the way you would end up releasing capital from where you are today is probably you'd have to show that you're having lower and lower risk profile under stress. And that may happen, but that's really not a topic that I think is out there today.
In other words, be prudent and be patient. It's not that the bank isn't confident in its business model and its ability to generate shareholder returns. It's just that in the banking industry today, it's not prudent to rush forward with overly ambitious plans. That would be asking for trouble and major setbacks. Bank of America can speak to that state of affairs.
As we go into this [stress] test, it's an evolution. So my sense is that from a pure capital perspective, you see in the test that there is not a need, given our risk profile, to have higher capital levels. But I think the rest of that process is to make sure that our risk management processes to keep monitoring that are very, very sustainable. That's the phase we are in now. And then as we check that box, I think our job is to get back to normal distributions and get the capital up there back to the investors.
Of course, prudence and patience come easy to M&T Bank; the company has been doing it for over 30 years. The bank strives to make only good loans in good times and bad, it doesn't overextend itself, and it differentiates itself by consistently running an incredibly efficient operation.
M&T Bank seeks to be steady, and over the long term that approach has worked very well. It's a lesson that Bank of America should take to heart.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.