RBC Capital Markets said banks with strongest capital and increased profitability are expected to get green light on dividends. The Federal Reserve is expected to approve dividend increases.

What Does SCAP Mean? A financial stress test conducted by the Federal Reserve System to assess the capital buffers of U.S. banking organizations. The Supervisory Capital Assessment Program (SCAP) took place in the spring of 2009 during the financial crisis of 2008-2009 and was intended to measure the financial strength of the nation's 19 largest financial institutions going forward.

The stress tests were limited to banking organizations with assets in excess of $100 billion; banks that the Fed considered 'too big to fail', according to Investopedia.

On Feb. 9, 2009, Treasury Secretary Timothy Geithner said the nation's largest banks would be subjected to a so-called stress test to determine whether they had enough capital to weather a steeper-than-projected downturn and still have enough funds to continue lending. Geithner said the examination was meant to reduce the uncertainty surrounding the financial system, as investors wondered about the value of mortgage-related securities held by the nation's largest banks.

The requirements of the stress tests measured each institution's Tier 1 common capital against a baseline scenario and a hypothetical scenario that was deemed more adverse. The results of the tests were released on May 7, 2009. The final results showed that 10 of the 19 banks were deemed to have inadequate capital. That being said, every bank tested met the legally mandated capital requirements.

On May 7, federal regulators said 10 of the 19 banks examined would need to raise $75 billion by November. The banks ordered to raise more capital included the Bank of America Corp. (BAC), Citigroup Inc. (C) and Wells Fargo & Co. (WFC). The tests in effect divided the banking industry into two tiers, with institutions like JPMorgan Chase & Co. (JPM), Goldman Sachs Group Inc. (GS) and American Express Co. (AXP) given clean bills of health.

The regulators said that under the test's worst-case scenario, the losses by the 19 banks could total $600 billion this year and next, or 9.1 percent of the banks' total loans.

Dividend Increases Could Be Coming Sooner

"We believe the Federal Reserve will give early approval to a handful of the Supervisory Capital Assessment Program (SCAP) banks to increase their dividends, possibly within two weeks, enabling them to increase their dividends in first quarter of 2011," said Gerard Cassidy, an analyst at RBC Capital Markets.

Of the traditional commercial banks, Cassidy believes Bank of New York Mellon Corp. (BK), Capital One Financial Corp. (COF), JPMorgan Chase, PNC Financial Services Group Inc. (PNC), State Street Corp. (STT), U.S. Bancorp (USB), and Wells Fargo could win early approval to increase their dividends.

In Cassidy's view, dividend increases should approach 30 percent of current earnings. Cassidy believes 30 percent payout ratios will be the new normal with buybacks eventually being utilized to manage excess capital levels later in 2011 and/or early 2012.

Not All Banks Likely to Be Treated Equally

Based on the Federal Reserve release late last year, banks that still have Troubled Asset Relief Program (TARP) on their books will not be permitted to increase the dividend.

The Troubled Asset Relief Program (TARP) is a program of the United States government to buy assets and equity from financial institutions to strengthen its financial sector, which is a component of the government's measures in 2008 to address the subprime mortgage crisis. It was signed into law by U.S. President George Bush on October 3, 2008.

SCAP banks that have not paid back TARP include KeyCorp (KEY), Regions Financial Corp. (RF), and SunTrust Banks, Inc. (STI), according to Federal Reserve.

"We believe BB&T Corp. (BBT) is 'stuck between a rock and a hard place' when it comes to increasing its dividend. BBT did not reduce its dividend as much as the other SCAP banks and, as a result, its payout ratio today exceeds 30 percent. We expect that it will be able to increase its dividend but only nominally," said Cassidy.

Early Dividend Increases not Fully Discounted by Market

Cassidy believes a earlier-than-expected increase in the common stock dividends for the aforementioned stocks would be viewed favorably by the market. Furthermore, with investors extrapolating a potential 30 percent payout ratio to normalized earnings, stocks would likely get a boost.

For example, JPMorgan's current dividend is 20 cents a share; using normalized earnings of $7.00 implies a $2.10 a share dividend, a 10 times increase in the dividend over the next 2-3 years, in Cassidy's view.

Dividend Income Investors Likely to Buy Bank Stocks

Cassidy believes as dividends are increased, dividend income investors will be attracted to these stocks. Many income-oriented portfolio managers have avoided these stocks due to the paltry dividends but Cassidy believes that is about to change.

 

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Source: SNL Financial, RBC Capital Markets estimates