Fed Green Light on Dividends Now Could Bring Trouble Down the Road

In the next couple weeks, the Federal Reserve Board will outline how it plans to loosen the reins on dividend payments by the largest banks. The central bank aims to send an encouraging sign to investors: the economy is stable and the giant banks are safe.

It's a gamble with some downsides.

For one, regulators may come off as caving to the enormous pressure that banks like JPMorgan Chase & Co. have been applying. It also muddies the message the regulators have been sending about more and better capital.

But the biggest question is whether the Fed is moving too soon. What happens if the economy deteriorates, if the credit cycle double dips? Would the banks that got the go-ahead to pay dividends have to turn around and cut them? Talk about unnerving investors.

Imagine this scenario: early next year the government lets JPMorgan Chase increase its payout to shareholders. Wells Fargo & Co. follows. Then U.S. Bancorp. By this point Citigroup Inc. and Bank of America Corp. are seething, leaning hard on their regulators to let them follow suit. The regulators are forced to let them renew payouts, too.

Next summer, the economy hits a wall. Unemployment hasn't improved and consumer spending (including borrowers repaying loans) takes another dive. Or interest rates spike. What happens to bank profits? They drop, and everyone asks why the regulators turned the dividend spigot back on.

It's not a far-fetched scenario, so you have to wonder what the regulators are thinking.

It's largely this: without a healthy dividend the large banks will not be able to satisfy their shareholders, who will move their money to other stocks. (Some large banks are complaining that investors are moving to the Canadian banks, which do not face the same regulatory constraints.)

Happy investors feed capital ratios, and a well-capitalized bank feeds economic growth through the loans it makes.

It all makes sense, and I am sure the Fed will approach this in its usual cautious manner. Each large bank will be assessed individually, and approvals will be made quarter by quarter. In other words, if JPMorgan Chase gains approval to boost its dividend in the first quarter, it will have to come back and ask the Fed again for the second-quarter payment.

A bank seeking to lift its payout will have to prove it has enough capital to meet requirements laid out in Basel III and the Dodd-Frank Act and enough reserves to cover expected losses.

The Fed intends these guidelines to serve as a carrot, encouraging banks to improve their capital management.

But why now? The agreement among international regulators in September on the Basel III framework served as the anchor for the decision, but it goes beyond that. At some point the Fed wants to start differentiating among banks again.

"We now no longer have separate firms in this country," said a source who has been briefed on the Fed's coming guidelines on dividend payments. "For all practical purposes, we have one big banking sector."

The homogenization of the industry began in fall 2008 when government officials insisted every large financial institution take billions under the Troubled Asset Relief Program.

But the crisis has passed and the Fed wants to take a small step toward differentiating firms.

That could backfire.

Banks that do not win the Fed's approval may be punished in the markets, and it could create a whole new "too big to fail" wrinkle.

"You are going to have the Fed saying, 'These are the healthy banks and can pay dividends, and these banks are not,' " said Lawrence Baxter, a professor at Duke University School of Law and a former executive at Wachovia. "That seems to me to compound the problem of 'too big to fail,' and it seems to grant [the healthiest banks] a competitive advantage."

And while the biggest banks did put up big second- and third-quarter profit numbers, they did it by releasing loan-loss reserves. That's unsustainable and it's unclear what business lines are going to feed the giants' future earnings.

With the bailouts still fresh in the public's mind and Dodd-Frank reforms not yet implemented, to take the lid off dividends leaves some with the impression that regulators aren't standing up to the banks. "This is big-bank lobbying in full-dress uniform," a former regulator told me. "I thought it would be another year at least before they started rounding the edges off their tough new supervisory approach."

Finally, the future remains uncertain. No one knows how and when interest rates will rise, when we will reach a bottom on bad loans or when unemployment will recede. All those factors are key to bank earnings.

The Fed wants the banking business to return to normal, and that's great, but it needs to make sure banks don't get ahead of the economy or the credit cycle. Because if the Fed has to clamp back down on dividends, the impact will be much worse than if it simply made the banks wait a couple more quarters.