It isn't unreasonable to think that Bank of America's (NYSE:BAC) shares will move a lot this week. Everything turns on the bank's ability to satisfy regulators on Wednesday with an updated version of its stress test submission.
One of the biggest changes to the way banks operate since the financial crisis is the fact that regulators now have veto power over banks' capital plans. If a bank wants to increase its dividend, or buy back more shares of common stock, it needs the Federal Reserve's permission to do so. This is the purpose of the comprehensive capital analysis and review process, or CCAR.
The CCAR process, which takes place in March, gives regulators the opportunity to assess whether the nation's biggest banks have enough capital to survive an economic downturn akin to the 2008 crisis. If they don't, or if regulators find deficiencies in a bank's capital-planning process, then the Fed will typically prohibit the offending bank from increasing its dividend or buying back more stock.
This has happened to Bank of America in three out of the last five tests. In this year's version, while regulators did not object to the Charlotte, North Carolina-based bank's capital plan, it required the bank to submit a new plan by Sept. 30th to "address certain weaknesses in its capital planning processes." This follows on the heels of last year's test, which Bank of America only conditionally passed after belatedly discovering a $4 billion discrepancy in the value of certain securities inherited via its 2008 acquisition of Merrill Lynch.
Analysts and commentators who follow Bank of America believe the issues in this year's test explain why former CFO Bruce Thompson is no longer with the company, seemingly ushered out of the bank as a part of an overhaul of the corporate suite.
This is also uniquely problematic for Bank of America, as it continues to operate "under restrictions imposed by a secret regulatory sanction, first issued in 2009, that criticized its ability to assess risk," reported The Wall Street Journal in June. On top of this, regulators recently downgraded Bank of America's community-lending rating, which reflects the bank's compliance with related laws.
To be fair, Bank of America isn't the only bank to struggle in stress tests over the past few years, which seems to suggest that there are issues with the tests themselves. For instance, JPMorgan Chase and Goldman Sachs, two of the best and most sophisticated companies in the financial industry, reduced their capital requests prior to this year's CCAR process after the Fed criticized their assumptions about future risks. And Citigroup's CEO Michael Corbat said he would resign if the New York City-based bank ran into problems yet again -- fortunately for Corbat, it didn't.
All of this goes a long way toward explaining why Bank of America's shares trade for a substantial discount to book value. "The general belief is that [Bank of America's] capital is trapped," Charles Peabody, an analyst at Portales Partners, told The Wall Street Journal. Its stress-test problems, Peabody continued, "puts a cap on their ability to raise their dividend and/or buy back shares. That is a concern, because it has a big impact on how the stock should be valued."
To this end, Bank of America's shares currently trade for a 27% discount to book value, while shares of Wells Fargo are priced at a 56% premium.
In sum, assuming that Bank of America is able to clear this latest hurdle, it seems reasonable to assume that investors will reward it with a higher stock valuation. The alternative, of course, is that it stumbles again and suffers the wrath of the market.
John Maxfield has no position in any stocks mentioned. The Motley Fool owns and recommends Wells Fargo. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.