By Sinéad Carew
(Reuters) - Shares in the biggest U.S. banks rallied on Friday after they passed the Federal Reserve's annual health check, but Bank of America (NYSE:BAC) underperformed with test results implying it needs a larger-than-expected capital buffer, which could limit share buybacks and dividends.
While the broader equity market also rallied on Friday, Wells Fargo (NYSE:WFC) & Co, up 7.5%, was the biggest gainer among the 34 lenders that underwent the Fed's so-called stress test, which measures how they would fare in a hypothetical severe economic downturn.
The group would have roughly twice the capital required under Fed rules in the downturn scenario, it said.
"The big picture is that banks are extremely well capitalized and could manage through a downturn," David Konrad, analyst at Keefe, Bruyette & Woods (KBW).
But the results implied a big variation in the size of banks' stress capital buffers (SCB) - an extra layer of capital banks must hold to cover potential losses and support their daily business which the Fed will set in coming weeks.
Banks expected to have to hike their stress capital buffers were Bank of America, Citigroup Inc (NYSE:C) and JPMorgan Chase & Co (NYSE:JPM), causing their shares to underperform on Friday.
Morgan Stanley (NYSE:MS) analyst Betsy Graseck said Bank of America, Citi and JPM may need to keep dividends flat and eliminate buybacks.
Those changes are likely to reduce Bank of America's earnings per share by 1-2%, said Graseck, who dropped her price target for the stock to $47 from $49. She estimated a 1-5% impact on Citi's EPS and cut her price target for that stock to $57 from $60. JPMorgan's EPS will drop 1-2%, she estimated, lowering her price target to $149 from $152.
KBW's Konrad also estimated that the three banks' "buybacks will have to be materially adjusted downward."
He sees the buyback adjustments shaving about 5% off EPS at Bank of America, and reducing EPS about 2% at JPMorgan and Citi.
Wells Fargo investors were relieved as its stress capital buffer is expected to remain almost unchanged from last year, Konrad said.
Bank of America shares closed up 0.7%, while Citigroup finished up 3.3% and JPMorgan ended with a 3.0% gain. The broader S&P 500 financial services index closed 3.8% higher.
The U.S. units of foreign banks performed well.
UBS Group AG (SIX:UBSG) closed up about 6%, while Credit Suisse (SIX:CSGN) added 5.5%. Other strong performers included Ally Financial, up 5.0%, and Discover Financial Services (NYSE:DFS), which climbed 5.4%.