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FARRA: Don't expect big dividends from banks anytime soon

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FarraBanks will not return to their status as reliable sources of shareholder dividends for three years or longer. Fed Chairman Ben Bernanke has driven deposit rates to zero, effectively forcing investors to consider dividends as an alternative source of income, but banks as a group will not be a source of these dividends.

Commercial banks emerged from the savings and loan crisis of the late 1980s with a renewed focus on returning earnings to shareholders via steady and rising dividend payments. This pattern continued into the 2000s, with banks a favorite pick for dividend-seeking investors.

That is, until the financial crisis of 2007-2009 nearly decimated the industry and the economy to boot. Massive losses and the acceptance of TARP funds from the federal government required the industry to reduce dividends to a scant amount in 2009 and have been slowly rising ever since.

Banking is certainly one of the most regulated industries. Polls suggest the public thinks banks should be held on an even tighter leash, reflecting the impact banks had on the economy and financial markets during the crisis years. With a high level of public and legislative mistrust, several obstacles will prevent banks from paying higher dividends in the near future.

1. Higher capital requirements. A bank’s protection from insolvency is its equity capital. These requirements have been revised several times following the two banking crises of the past 25 years (savings and loans in the late 1980s and the housing-inspired of 2007-2009). Congress passed the Dodd-Frank banking law in 2010, containing 2,300 pages of guidelines and more than 6,000 pages (and counting) of regulation.

Most bankers profess they still don’t know what rules to follow and therefore act cautiously when considering making loans. Forcing banks to carry higher capital positions will retard dividend growth.

2. Sluggish loan growth. “Drop in Borrowing Squeezes Banks” read the headline in The Wall Street Journal on April 26. While bankers may be ready to make new loans to creditworthy customers, commercial loan customers are instead hoarding cash or paying cash for large expenditures. Large publicly traded companies are bypassing banks to issue corporate debt to lock in generationally low interest rates.

Finally, individuals are more focused on thrift, paying down credit cards and increasing savings. These trends are not likely to change overnight.

3. Declining gross profit margins. Banks earn a spread between interest they earn from loans and investment securities and interest paid on deposits and other borrowings. With no loan growth and investment yields at 4 percent or lower, bank margins have been slowly declining the past four years and are not a recipe for higher dividend payments.

4. Ongoing regulatory and political overhang. Banks have been the convenient scapegoat for the country’s ills the past three election cycles going back to 2008.

Additionally, the worry about the government debt crisis in Europe spreading around the world (many large U.S. banks do business with their brethren around the globe) has forced U.S. regulators to expand their oversight to previously less-risky areas of a bank’s business.

Other than loans to healthy companies and consumers (who most likely are not borrowing, anyway), banks are finding fewer profitable loan opportunities given the regulatory risk they face.

Events such as the huge losses incurred by JPMorgan Chase from the so-called London Whale in spring of 2011 will keep regulators watching daily activities to ensure another such disaster does not happen again. Measured risks are necessary for a bank to increase earnings, but the regulatory environment runs counter to that need.

5. Too many banks. There are more than 9,000 banks with assets over $100 million and scores more smaller community banks. Most markets are over-banked, meaning too many lenders chasing too few loans and too many branches in an era of greater use of electronic banking services.

The high fixed costs of operating a bank are not being offset by loan growth; at some point, there will be another wave of consolidation and a marked reduction in the number of physical bank locations. Neither trend will auger well for higher dividends.

Economists have cited the increasing use of financial service products as a primary driver of economic growth from the early 1980s through the onset of the financial crisis. This trend has since been reversed and the economy should benefit in the long run from lower debt levels and greater cash and equity in daily transactions.

The banking system is measurably stronger than it was five years ago, but the price paid for this strength is lower profits returned to shareholders in the form of cash dividends.•

__________

Farra is a co-founder of Woodley Farra Manion Portfolio Management Inc. Views expressed here are the writer’s.

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