Emboldened by the Federal Reserve’s passing grades on stress tests of banks, some of the nation’s biggest financial firms are racing to dole out billions of dollars in dividends.
But some industry analysts and academics say that it is too soon and that it could threaten to put banks on shaky ground.
Such moves deplete the capital cushions of banks, potentially making them far more vulnerable to withstanding sudden market shocks.
“It’s frankly irresponsible to allow banks to quickly empty their coffers,” said Neil Barofsky, the former inspector general for the Troubled Asset Relief Program. “They should be holding onto this money.”
Another potential problem is that stress tests might overstate the health of banks, Mr. Barofsky said.
On Tuesday, the Federal Reserve concluded that 15 of the 19 banks it examined would be able to maintain a minimum capital level during a severe economic crisis. That cleared the way for those banks to bolster dividend payments to shareholders and initiate a round of share buybacks.
It also set off a debate among economists and banking analysts about whether banks have actually achieved renewed strength.
“The Fed has essentially appeased critics and proclaimed the banks healthy without doing real due diligence,” said Anat R. Admati, a professor of finance and economics at Stanford.
The Fed has maintained that its examination of banks was extremely rigorous. On Tuesday, a senior Federal Reserve official countered any worriesabout the health of most banks, noting that despite dividend plans, the banks would all have more capital by the end of the year than they had at the start of the year.
That is because banks, even after increasing shareholder payouts this year, will still retain more profits because the dividends will be lower than they were before the financial crisis. Despite paying out dividends last year, they bolstered their capital by $52 billion in 2011.
Healthy banks should be able to reward their shareholders with dividend payments, some banking analysts said.
“The scenarios were incredibly severe, and the banks fared extremely well,” said Michael Scanlon, a senior equity analyst with Manulife Asset Management in Boston.
First out of the gate, JPMorgan Chase announced Tuesday that it would buy back roughly $12 billion in stock this year and increase its quarterly dividend payment by a nickel, to 30 cents.
Others quickly followed suit, bolstered by passing the Fed’s test. Wells Fargo increased its dividend by 10 cents, to 22 cents. John Stumpf, the bank’s chairman and chief executive said, “We are extremely pleased to reward our shareholders.”
American Express , the credit card issuer, also announced it would increase its quarterly dividend by 2 cents, to 20 cents a share. Meanwhile, U.S. Bancorp raised its quarterly dividend, too, by 7 cents, to 19.5 cents.
The latest tests were the third that banks have been subjected to in the wake of the financial crisis. While some complained that the tests were too harsh, forcing industry titans like Citigroup to shelve plans for a dividend payment, some economists, including Professor Admati, have raised an alarm, saying the tests were not hard enough.
“Why are we letting banks hand out dividend payments and encouraging risky behavior after they passed flimsy tests?” she said. “It’s frankly dangerous, and the Fed should not allow it.”
Rebel A. Cole, a former Fed economist and a professor of finance at DePaul University, said that the stress tests created too rosy a picture, drastically understating how a financial crisis would impact banks’ balance sheets.
Even though the tests assumed a grim economic situation, with unemployment surging to 13 percent and housing prices plummeting by 21 percent, they failed to register how deeply banks’ holdings, like mortgages and credit cards, would suffer.
For instance, the tests assumed that banks could lose up to $56 billion on home equity lines of credit and second-lien mortgages, or roughly 13 percent of their portfolio. That’s too low, Mr. Cole said. “Those loss rates don’t even pass the smell test,” he said. In an economic downturn, more underwater homeowners would default on their loans, he said.
Another problem with the tests, critics said, was that they underestimated the legal liabilities that might still be lurking for banks as they work through a backlog of soured mortgages.
In its analysis of Bank of America , the Fed predicted the firm could withstand up to $60 billion in losses over the next two years, without increasing its current dividend of 1 cent a quarter. But Professor Cole said that Bank of America’s liabilities on those mortgages — especially if the bank has to pay more money to investors who are demanding that the bank reimburse them for losses on mortgage bonds — could far exceed that $60 billion mark.
In addition, the Fed too heavily relies on 2008 and 2009 to create its nightmare economic situations, he said. For example, the Fed situation expected that interest rates on 10-year Treasurys would plunge to 1.64 percent, without factoring in a different circumstance where interest rates could surge and undercut loan demand.
In addition, the tests did not take into account difficulties that the banks might face in borrowing money. Without that, the tests could potentially be incomplete, Mr. Barofsky said.
Instead of allowing banks to return money to shareholders, the Fed should force them to retain it, he said. “In this case, the Fed is acting as enabler,” he said.
Banks had long been a reliable source of income for shareholders through dividends, until the rising payouts were essentially wiped out as the financial crisis crippled the banks and they sought federal money to survive. Shareholders have been pressuring banks to increase the payouts, eager to recoup losses on financial stocks.
Citigroup was among those that were not permitted to raise dividends. It had paid a hefty 54-cent quarterly dividend to shareholders before the financial crisis. Now, the bank pays 1 cent a share. The Fed quashed Citi’s latest effort to increase dividend payouts for shareholders. The regulator determined that despite two years of profits, Citi would not have enough capital to increase its dividend payments while still weathering a financial crisis even more severe than 2008’s. Neither Citi nor the Fed disclosed how much the bank wanted to raise the payout.
Still, Citi will try again, resubmitting a revised proposal to the central bank later this year.