Are Banks Ready For Dividends?

Federal Deposit Insurance Corporation (FDIC) insured banks earned $21.7 billion in the fourth quarter of 2010, and $87.5 billion for the full year the highest since 2007. So, shouldn't the banks be sharing those profits with investors? Insured institutions paid $53.9 billion in dividends in 2010, an increase of $6.7 billion (14.3%) over 2009, but less than half the annual record of $110.3 billion paid in 2007. At first sight, a 14.3% increase in cash dividends that the banks paid seems to be appealing, however, given the current inflation and expectations that seems to be not so appealing. What/who is preventing the banks from paying higher dividends? Are the banks actually ready for higher dividends? Some good news first On March 18th, JP Morgan Chase & Co., U.S Bancorp, Wells Fargo, and BB&T Corporation announced higher dividends and authorization to repurchase shares after the Federal Reserve gave the green light for select large U.S. banks to hike dividends. On March 21st, Citigroup Inc announced a 1 for 10 reverse stock split, effective after the close of trading on May 6th 2011. It also announced that it intends to reinstate a quarterly dividend of $0.01 per share in Q2 FY2011, following the effective date of the reverse stock split. On the same day, State Street increased its dividend from $0.01 to $0.18 per share. On March 23rd, Bank of New York Mellon increased its quarterly dividend 44% from $0.09 to $0.13 per share for Q2 FY2011 and authorized a $1.3bn share repurchase program. On the same day, Fifth Third Bancorp declared a Q1 FY20'11 cash dividend on its common shares of $0.06 per share, a 500% increase from its previous quarterly dividend rate of $0.01 per share. Discover Financial Services announced a 200% increase in the cash dividend from $0.02 to $0.06 per share. Forecast Among the S&P Dividend Aristocrats, Chubb Corp was the lone financial services company to announce dividend increase in February 2011 ”“ this could force AFLAC Inc, and Cincinnati Financial to follow suit soon. In 2007, financial services companies were the top dividend contributors with a share of 29.12% of total dividends paid by S&P 500 companies. Dividend yield from financial services companies was also the second highest at 3.32% among the S&P 500 companies. However, in 2010, dividend contribution from the S&P 500 financial services companies fell to 9.06%, placing them at sixth position among the 10 sectors in the S&P 500. Among the S&P 500 financial services companies, year-to-date (March 22, 2011) only 71 companies paid dividends, compared to 89 companies in 2007 or 69 companies in 2010. As the year progresses, I expect more financial services companies to pay higher dividends.  Now the key question, are the banks ready for dividends? A look at the table given below suffices to show that the state of financial services industry's (at least as far as FDIC insured institutions are concerned) environment has improved significantly. However, the table also suggests that much still needs to be done. One should recollect that, regulatory authorities (the US administration, FDIC) restricted dividend payments by financial services (mostly banks and insurance companies) in the wake of the unprecedented financial crisis in order to preserve capital. The efficacy of that regulation is evident from the improvement in core capital (leverage) ratio from 7.4% at end 2008 to 8.74% at end 2010. Recently, S&P said that it "remains wary of banks aggressively increasing capital returns to shareholders at this juncture of the economic recovery." I agree with this view. If regulations to restrict dividends are not in place, history shows that, banks would pay dividends (due to stock market pressures) despite their ability to do so. For instance, even though the industry's dividends fell by more than half in 2008 compared to 2007, the $51.0 billion paid out in 2008 exceeded the year's net income by almost $41 billion. As a result, core capital (leverage) ratio fell from 7.63% at end 2007 to 7.40% at end 2008. Banking industry is showing some signs of concern. For instance, revenue growth was sluggish in the fourth quarter of 2010. Net operating revenue (net interest income plus total non-interest income) was $163.6 billion, only $2.8 billion (1.7%) higher than a year earlier and $2.1 billion (1.3%) less than in third quarter 2010. This is the second-smallest year-over-year increase in quarterly net operating revenue in the past two years (after the $911 million year-over-year increase in second quarter 2010). Moreover, a significant part of industry's bottom line improvement in Q4-2010 is attributable to improvement in asset values, in the absence of which revenue visibility is below satisfactory. Additionally, the industry's balance sheet is not as strong as to allow unrestricted dividend policies. For instance, in the fourth quarter of 2010, reserves for loan and lease losses declined for a third consecutive quarter, falling by $11.1 billion (4.6%), as net charge-offs of $41.9 billion exceeded loss provisions of $31.6 billion. Four large banks accounted for more than half of the decline in industry reserves, as more than a third of all institutions (39.4%) reduced their loss reserve balances in the fourth quarter. So, net on net, I think, the banking industry is not yet ready for pre-crisis dividend payout levels.... Read more