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Stock Strategist Industry Reports

Several Undervalued Banks Stand to Benefit From Fed's Review

We see the CCAR results as most positive for Wells Fargo, Capital One, and Citi.

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All 34 banks undergoing the 2017 Comprehensive Capital Analysis and Review by the Federal Reserve Board received a non-objection to their capital plans. The CCAR is important, because it reaffirms the resilience of the large U.S. banks in a severe economic downturn and is the constraint on capital returns. At the aggregate level, banks were approved to roughly return as much capital as they were projected to generate between the third quarter of 2017 and second quarter of 2018. We see the results as most positive for  Wells Fargo (WFC),  Capital One Financial (COF), and  Citigroup (C), which should be able to repurchase their shares at a discount to our fair value estimates. We are maintaining our economic moat ratings and fair value estimates for the U.S. banks.

While the board gave a non-objection to Capital One’s proposed plan, it’s on the condition that the company will resubmit its capital plan by Dec. 28. The Fed release stated, “Notable weaknesses were identified in the oversight and execution of the firm’s capital planning practices, which undermined the reliability of the firm’s forward-looking assessment of its capital adequacy under stress. Specifically, the firm’s capital plan did not appropriately take into account the potential impact of the risk in one of its most material businesses.” Neither the Fed nor Capital One provided any additional color on what material weaknesses the company must address. However, we don’t believe this represents a substantial risk to the company’s business or our fair value estimate of $102 per share. Despite the conditional approval, Capital One can still repurchase as much as $1.85 billion in shares by the end of June 2018 and is expected to pay a $0.40 dividend in August. For perspective, last year  Morgan Stanley (MS) received a conditional non-objection that it successfully addressed by year-end, and it has been able to carry out its capital plan.

While we consider the overall results for the banks that we cover to be good, next year’s approved capital returns could be significantly higher than at any time since the CCAR was implemented. First, banks have increased their capital by more than $750 billion since 2009. Second, they’ve been refining their business models to generate better risk-adjusted returns and optimizing their balance sheets under both pure leverage and risk-based regulatory capital calculations. Third, the current administration has a deregulatory mindset, and it’s conceivable that it will change how the stress test is done so that banks can return more capital. For example, the United States could make some adjustments to its regulatory capital standards and testing, which are generally more stringent than the baseline Basel rules, such as how it applies the supplementary leverage ratio or by not assuming that banks continue to return capital in the severely adverse scenario. Even this year’s CCAR shows a step in the banks’ favor via the removal of the qualitative assessment for large and noncomplex firms, which were 21 of the 34 banks tested. Banks being able to return more than 100% of earnings means a decrease in equity capital, higher returns on equity, and often a higher valuation.

As we expected, Citigroup’s renewed profitability and capital strength allowed the bank to significantly boost returns, doubling its quarterly dividend to $0.32 per share and authorizing $18.9 billion in repurchases. For comparison, Citigroup’s 2016 capital plan, released after last year’s CCAR results, consisted of a $0.16 per share quarterly dividend and as much as $8.6 billion in repurchases beginning in the third quarter. Later in the year, the company announced an additional $1.75 billion in repurchase authorization. The most recent announcement implies that Citigroup could buy back as much as 10% of its current market capitalization over the next 12 months. The company trades below our $74 fair value estimate and may be newly interesting to dividend investors as its yield rises.

Morgan Stanley continues to have more capital return potential than  Goldman Sachs (GS). In the severely adverse scenario, Morgan Stanley’s common equity Tier 1 ratio was 3.4 percentage points above the 4.5% regulatory minimum, while Goldman Sachs’ was only 1.5 percentage points above. Morgan Stanley was able to maintain this buffer despite its capital plan including as much as $5 billion of common stock repurchases and an increase in the quarterly dividend to $0.25 from $0.20. This amount of capital returns may actually be more than Morgan Stanley’s projected net income and allow it to start drawing down capital and increasing its return on equity. Some may point to other ratios where Goldman Sachs and Morgan Stanley were quite close to the regulatory minimum, such as the Tier 1 leverage ratio and supplementary leverage ratio, but we believe these ratios can be effectively addressed by issuing preferred stock.

Michael Wong does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.