COVID-19 pressures led to significant declines in earnings and waning regulatory capital ratios for most banks in the first quarter. With this as the backdrop, new focus has emerged on whether U.S. banks should--and could--keep paying their common equity dividends. While a cut in those payouts wouldn't in and of itself trigger a rating action, the reason behind it could add to rating pressures in certain cases.

To be clear, all U.S. banks we rate have regulatory capital ratios above their current required minimums, including their regulatory buffers, meaning they currently have no technical restrictions on distributions. Also, in a speech in early April, Federal Reserve Chairman Jerome Powell said that he saw no reason "at this time" why U.S. banks would need to suspend dividends to preserve capital during the deepening coronavirus economic crisis. Many U.S. banks, including but not limited to the globally systemically important banks (GSIBs), announced in March that they would cease share repurchases--which for most banks comprise the bulk of their payouts--at least until the end of the second quarter in order to prioritize capital preservation. But they aren't planning to change their dividend policy based on the economic stress they see ahead.

Still, given the uncertainty about the ultimate magnitude of economic stress due to the pandemic, losses could be substantially higher than we currently expect. If this occurred, some banks may choose or be required for regulatory reasons to cut their common dividends for a variety of reasons.

A bank may do so to preserve or bolster capital, for example, if its income were to fall below the amount of dividends it plans to pay out. It may even do so out of necessity, given regulations that generally limit the dividends of commercial banks to the current year's net profits and retained net profits of the two preceding years. Those regulations are relevant for the bank holding companies we rate that rely on upstreamed dividends from their commercial bank subsidiaries to finance the dividends they distribute to their own shareholders (and reflect why we rate these entities lower than their subsidiaries).

Banks may also need to cut their common dividend in an effort to keep their regulatory capital ratios above their capital conservation buffers. Banks must maintain those buffers above their minimum capital requirements in order to avoid limitations on capital distributions and discretionary bonus payments. For the largest banks, with assets greater than $100 billion, capital conservation buffers--currently set at 2.5% for all banks--may increase due to the implementation of the stress capital buffer (see "The Fed's New Rules Change Capital Management Dynamics For U.S. Banks," published March 19, 2020). These banks' capital conservation buffer will depend on the outcome of this year's supervisory stress test, due to be released in June, but will be at least as high as the current 2.5%. We continue to expect the new capital conservation buffers will go into effect Oct. 1.

Lastly, regulators and policymakers may ask banks to cut their dividends as a precaution to ensure that they have the capital to continue making loans to support the economy.

The Ins And Outs Of The Possible Timing Of A Dividend Cut

Currently, roughly one-third of the U.S. banks we rate have negative outlooks. Whether we ultimately downgrade those banks will depend largely on the duration of the pandemic and strength of the economic recovery. Based on a stress test we ran, we concluded that we would likely lower many ratings in a "severely adverse" scenario and a more limited number in an "adverse" scenario (see appendix tables 4 and 5 for the assumptions behind those scenarios and chart 2 for the cumulative results of our stress test).

But even if banks don't come under substantial stress, some may still cut their dividends because of declining income, declining capital levels, or higher capital requirements resulting from the stress test.

So far, only one bank we rate has cut its dividend this year. In late April, Cadence Bancorporation (BB+/Negative/--) cut its quarterly dividend to 5 cents per share from 17.5 cents per share, after a large goodwill write-down led to a loss in the first quarter. Although capital ratios were not affected as a result of this loss, it depleted the earnings its subsidiary bank had retained in the prior two years. As a result, the company disclosed in its 10Q that the bank could not upstream dividends to its holding company without seeking prior approval from its regulator. It's possible that other banks, upon the release of their second-quarter results, could join Cadence in cutting their common dividends.

The largest banks could also cut dividends in June upon the release of results of the Fed's stress test. Randal Quarles, the Vice Chairman for Supervision of the Federal Reserve Board of Governors, recently indicated that the results of the stress test will determine if a dividend cut is needed. Greater estimated losses could result in higher stress capital buffers (SCBs) since the SCB is a measure of the difference between a bank's starting and minimum projected capital ratios in the stress test.

For GSIBs, a higher SCB would mean a greater buffer requirement, because the buffer is the sum of a bank's SCB and its GSIB surcharge. Upon release of the stress test results, some of the banks that participated in the test may have capital ratios that are below their buffers. If that occurs, banks may opt to cut their dividends in an effort to build their capital ratios higher, particularly if they entered this period with relatively high dividend payout ratios.

In addition, the Fed has said it will conduct "sensitivity analyses" to examine banks' responses to COVID-19. The addendum of the stress test will consist of "alternative scenarios and certain adjustments to portfolios to credibly reflect current economic and banking conditions." This analyses could also determine whether a dividend cut is needed for select banks.

Finally, even if regulatory quantitative limitations are not triggered, we believe the Fed could encourage all banks that were subject to the stress test collectively to reduce their dividends. A blanket restriction by regulators would minimize bank-specific speculation and volatility, while also encouraging banks in the aggregate to preserve more capital in order to facilitate more lending.

What A Dividend Cut Means To Bank Ratings

If a bank cuts its dividends, this decision does not necessarily lead to a rating action. Instead, we evaluate the impact on a case-by-case basis, after considering the circumstances that led to the dividend cut. Common equity dividend cuts can be a positive for creditors as they preserve capital and lessen the chance of default. That said, historically, banks in the U.S. have tended to cut their dividends only when they are under substantial stress. Although a dividend cut helps preserve capital, it has historically typically signaled that something was amiss at the bank beyond expectations--a negative for the rating.

But, in the current environment, the signal from a dividend cut may not necessarily be as negative as in the past. For instance, the large banks are generally subject to higher capital requirements and tighter rules than in the past, meaning a dividend cut could occur sooner in a downturn than in the past and at a time that the bank's capital ratios are still well above minimum required levels. For example, for some large banks, a dividend cut could come even if their common equity tier 1 (CET1) ratios are well above 10%. (In table 7 in the appendix, we depict each of the rated banks' projected CET1 ratio, assuming our severely adverse stress scenario were to materialize.)

Furthermore, some banks entered this period with higher dividend payout ratios than others. If a bank were to cut its dividend as a defensive move to bring its dividend payout in line with peers, we may regard the net effect on creditworthiness to be more supportive.

If many banks were to cut their dividends in unison, perhaps orchestrated as a blanket cut by the Fed so as not to single any bank out and ensure that all banks can continue lending sufficiently, we would be unlikely to lower ratings (assuming no other adverse changes such as a worsening of our economic projections).

But an idiosyncratic dividend cut by a bank, to levels well below peer medians, could also indicate expectations of substantially weaker earnings capacity or disproportionately higher credit losses relative to peers. If the additional stress is higher than that embedded into our expectations for that bank, we would take the associated earnings pressure into account in our rating analysis, which could lead to a negative action for some banks. A common dividend cut could also result in a decline in market confidence, which we would also factor into our rating analysis.

Moves Banks Could Make To Avoid A Capital Buffer Breach

If a bank were to get close to breaching its capital conservation buffer, we would expect management to look for ways to prop up their capital ratios. Besides negative headline risk, including a decline of market confidence due to a buffer breach, executive bonuses would also be at risk, as a breach would likely necessitate a cut to bonuses as well.

We believe management's first move to preserve capital will likely be to limit balance-sheet and risk-weighted asset growth by slowing or shrinking loans, scaling back trading inventory, or selling assets. We believe it is also possible that regulators may require a dividend cut along with balance-sheet actions in this scenario to deter banks from engaging in procyclical balance-sheet management.

Recent Changes In Regulatory Capital Ratio Calculations Will Help Banks Stay Above Their Buffers

Now that the stress capital buffer rule has been finalized, regulators will require banks to stay above their buffers. That said, regulators have also offered some relief in capital requirements in the wake of the pandemic. One key change is the allowance build for the new current expected credit losses (CECL) accounting standard. Specifically, regulatory capital ratios will not decline commensurate with the hefty allowance builds. First, banks can add back the day-one impact CECL had on retained earnings (when it was implemented on Jan. 1, 2020) to regulatory capital. Second, they can assume that allowance build in 2020 and 2021 would be 25% lower under the incurred loss model than under CECL and add back the difference to regulatory capital. Those amounts added back to regulatory capital will be phased back in at 25% per year, beginning Jan. 1, 2022. We estimate that, as of the first quarter, the change has already boosted rated banks' CET1 capital ratios by about 30 basis points, at the median. We are not making these adjustments in our risk-adjusted capital ratios, and so there will likely be a higher divergence between regulatory ratios and U.S. bank RAC ratios, until the CECL phase out expires (roughly five years).

Regulators have also modified how supplementary leverage ratios (SLR) are calculated and excluded Treasury securities and deposits at the Federal Reserve from the calculation (effective through March 2021). The temporary modifications will provide flexibility for the largest banks subject to SLR to expand their balance sheets in order to provide credit to households and businesses struggling with the challenges arising from the coronavirus.

In addition, the final SCB rule did not include a stress leverage buffer requirement. Instead, banks will only be subject to nonstressed ongoing minimum leverage ratio requirements. That includes supplementary leverage ratios (5% for GSIBs and 3% for category II and III banks) and Tier 1 leverage ratios (4%).

Assessing Which Banks May Be More Susceptible To A Dividend Cut

To determine which banks may be more likely to cut dividends, we divided banks in two categories:

• The banks that pay out the most dividends relative to 2019 earnings, with lower regulatory capital ratios compounding any high payout ratios; and
• The banks that would breach their buffers under our severely adverse stress scenario.

Banks with a high percentage of dividends to earnings compared with consensus 2020 earnings

Current regulation permits a bank to upstream dividends from its bank subsidiary to the holding company level, but only if earnings at the bank are sufficient. Specifically, a bank may not declare a dividend to the holding company if the total amount of all dividends (common and preferred, including the proposed dividend), declared by the bank in any current year exceeds the total of the bank's income for the current year to date, combined with its retained net income of the past two years.

The banks at greatest risk of having to cut dividends are those with some combination of the highest percentage of dividends to 2019 earnings, the greatest declines in 2020 earnings, and the lowest capital. Given the deterioration in economic conditions since then, the percentage of dividends to net income for 2020 will likely rise and could even exceed actual 2020 earnings. Even if a bank had limits placed on the upstreaming of its dividends to the holding company, payments could continue as long as the holding company had sufficient resources. (Those banks are denoted in table 1, with cash and liquid securities at the holding company compared with liquidity uses, which include maintaining dividend payouts, greater than 1X.)

Table 1

Chart 1

Banks that breach their buffers under our severely adverse stress scenario

Another method we used to determine which banks may be more likely to cut dividends was to incorporate the results of our severely adverse stress test. Our current base case does not involve such a level of stress. We focused on the banks whose risk-weighted capital ratios would fall below their capital conservation buffers under our stylized stress assumptions. Specifically, for most banks they would need to breach a 7.0% CET1 capital ratio, 8.5% tier 1 capital ratio, or 10.5% total capital ratio. For the largest banks, the breach minimum is higher as it will include a stress capital buffer and a GSIB buffer for the eight largest banks. A dividend cut could also arise if banks were to breach their TLAC minimum ratios or their leverage ratios. We did not analyze the latter two ratios as part of our analysis because we think most banks are more likely to breach a capital risk-weighted ratio first; moreover, only the eight GSIBs are subject to TLAC regulation.

Just because a bank breaches its capital buffer doesn't mean it automatically needs to stop paying its dividend. According to rules set forth by the regulators, a dividend cut depends on whether a breach has occurred at the end of a quarter, the extent of the buffer breach, and the banks' last four quarter earnings.

Assuming a breach of a capital buffer occurred at quarter end, regulators will assess the extent of it. Guidance from the Fed, which was also mentioned in the stress capital buffer final rule, suggests regulators will calculate the percentage of "eligible retained income" permissible to be paid out as shareholder distributions and executive bonuses (see appendix table 3 for how regulators mandate permissible percentage payout based on the size of the buffer breach). They calculate eligible retained income as the higher of the following two items to determine the maximum distribution:

• Net income over a cumulative four quarters of net income, net of distributions and associated tax effects not already reflected in net income
• The average of a banking organization's net income over the preceding four quarters (i.e., gross of dividends)

A given bank's four-quarter net income average may be high enough so that a dividend cut is not required. But even for these banks, if trailing-four-quarter net income were to deteriorate in the quarters to come, it may be insufficient to pay the current dividend, should these banks breach their buffers.

For most banks, cutting the common dividend alone, while continuing to pay preferred dividends, would be enough to bring them in compliance with the maximum distribution limits. That said, we believe some banks may face limitations in their ability to pay all dividends in a severely adverse scenario, barring special consent from regulators. In the table below, we show which banks breach their buffers under our severely adverse stress scenario and whether a dividend cut would be required upon a breach. Notably, all banks' current capital ratios are either in excess of, at, or about at their required ratios, meaning earnings would need to decline or risk-weighted assets would need to grow for banks' capital ratios to meaningfully fall below required levels.

Table 2

How a cut in a bank's common dividend could affect the preferred stock rating

A cut in a banks' common dividend is likely to lead to scrutiny on its ability or willingness to pay preferred dividends. If a bank's earnings were under pressure, and it was unable to upstream dividends from the bank level to the holding company level--resulting in a common equity dividend cut--whether the bank can continue to pay its preferred dividend will depend on the amount of liquidity already positioned at the holding company. If a bank were to breach its capital buffer, management has the option to reduce common equity dividends, executive bonuses, or preferred dividends. Given the impact on market confidence of a cut in preferred dividends, we would expect management to cut executive pay before cutting its preferred dividend. But if the capital buffer breach is significant enough (for instance, if the buffer is less than 62.5 basis points from the minimum capital ratio) or if its four-quarter average income is relatively small, it's possible that upon a breach of the buffer a bank could decide to stop paying its preferred dividends along with common equity dividends and executive bonuses.

We notch our ratings on U.S. banks' preferred stock from their group stand-alone credit profiles (SACPs). We typically rate preferred issuances three notches below the SACP for operating banks and at least a notch lower for hybrids issued out of the associated holding companies, reflecting our view of the combined risks of structural subordination and conversion to equity.

Although an ordinary dividend cut helps preserve capital (which is positive for creditors), if we believe that a bank is likely to face meaningful stress above that in our current expectations, we could consider lowering its SACP. Even if the SACP were unchanged, we could consider lowering the rating on a bank's preferred stock instrument to reflect growing risk of coupon or preferred dividend nonpayment.

Results Of The Stress Test Loom

We are weeks away from finding out the results of this year's stress test. In a statement to the Senate Banking Committee in mid-May, Fed Vice Chair for Supervision Randal Quarles indicated that, although regulation requires stress tests to be completed by the end of June, they could be completed sooner than that in the current environment.

There is a lot at stake for the banks, including whether their capital policy may have to change and whether dividends may remain intact.

Appendix

Table 3

Table 4

Table 5

Table 6

Chart 2

Related Criteria

• Hybrid Capital: Methodology And Assumptions, July 1, 2019

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