Financial Regulatory Forum

ANALYSIS-Fatter capital rules mean lean times for big banks

By Reuters Staff
September 8, 2009

By Kevin Drawbaugh

WASHINGTON, Sept 9 (Reuters) – Banking is supposed to be boring.

That’s the quip that lobbyists and congressional aides use, only half-jokingly, to explain what’s in store for the banking industry as governments crack down with tighter regulation.

From higher capital standards and tighter oversight, to slimmer profits and smaller bonuses, global banking promises to be a duller and less lucrative business in years ahead.

That’s not to say change is imminent. The international banking regulation process moves very slowly. But some industry analysts are convinced major changes are coming.

Nor does this mean that investors should shrug off the sector. To the contrary, analysts see opportunity in innovative, mid-sized boutique firms, developing markets, and banks that can create exciting, new savings products.

But for old-school Big Banks — the mega-institutions saved by last year’s bailouts — the future looks constrained, with officials constantly hovering, pinched margins, risks of political change, and a lingering odor of toxic assets.

Giants like Citigroup Inc or Bank of America Corp, for instance, might even respond by breaking up or spinning off units under intense scrutiny, analysts say.

Some see banks at the lower margin of the government’s unspoken “too big to fail” category purposely downsizing to attract less attention and gain freedom to operate.

One financial services lobbyist expects “DNA changing at some of the firms” as they adjust to a more restrictive world after the financial crisis of 2008-2009.

PricewaterhouseCoopers, the global accounting group, said in a recent report: “The banking industry and investors must accept an uncomfortable truth — lower returns on equity will become the norm.”

Bank research group Institutional Risk Analytics said in a recent report: “Last year people seemed primarily worried about the bank in which they kept their money.

“Now they are beginning to express an interest in redeploying their capital to reward best-of-breed banks … to find out who the healthy survivors will be.”

G20 ON CAPITAL

Finance ministers of the Group of 20 large industrial nations broadly agreed over the weekend that banks ought to hold more capital as a cushion against major losses.

The G20 ministers’ final statement from a London meeting said banks will “be required to hold more and better quality capital once recovery is assured.”

U.S. Treasury Secretary Timothy Geithner released a plan of core principles for new capital rules two days before the G20 meeting. More details are expected by the end of the year.

The capitalization question will also be a topic at the G20 summit meeting coming up on Sept. 24-25 in Pittsburgh.

Stricter capital rules — forcing banks to keep more ready resources on hand to back the loans they make — are expected by many analysts to be on the books, possibly as soon as 2012.

This could be accomplished largely by regulators through accords such as the Basel agreements, or something like them. Little involvement by politicians would be needed, reducing the chances that higher standards could become bogged down like other financial reforms now before U.S. Congress.

“Higher capital requirements reduce bank profitability. This would be especially pronounced at the biggest banks,” says policy analyst Jaret Seiberg at research firm Concept Capital.

“We believe it is highly likely that most of (Treasury’s) core principles will find their way into new bank capital rules, though action is not imminent,” Seiberg says.

CHRONIC WEAKNESS IN CREDIT DEMAND
Besides a profit pinch from higher capital requirements, banks — both commercial banks and Wall Street firms that have converted to bank holding companies — face other threats in the aftermath of the 2008-2009 financial crisis.

Some analysts expect chronic weakness in credit demand, although an upsurge in economic growth would relieve that.

Toxic assets — non-performing exotic securities left over on many banks’ books from the real estate bubble — will be a long-term drag on earnings. Accounting changes have eased their impact on the bottom line, but most analysts say the industry has yet to deal conclusively with this problem.

A severe contraction in the debt securitization markets will impede a revival in new lending, as would the emergence of limits on moving assets off the balance sheet, analysts say.

New over-the-counter derivatives rules, if enacted, “will significantly impact and reduce the supra-normal profits earned by major OTC derivatives dealers such as JPMorgan Chase & Co and Goldman Sachs Group Inc,” says Institutional Risk Analytics.

New capital standards may incorporate counter-cyclical features requiring banks to sock away more resources during good times, limiting gains and requiring internal adjustments.

Brand values and customer loyalties have been hurt by the crisis, presenting banks with marketing problems.

PricewaterhouseCoopers says the industry’s image has suffered so badly it may have trouble recruiting bright, young college graduates to its ranks in the future. Possible limits on bonuses could make recruiting even harder.

Also, low interest rates curtail banks’ deposit margins by restricting the spread between the rates they pay for deposits and the rates they charge for loans.

TARGET LIST
It’s not all gloomy, however. Analysts point to potential opportunities for bankers in the post-crisis period.
For instance, the government crackdown on OTC derivatives might also furnish new risk-management business as portions of the so-called “shadow banking system” fade away.

Consumers also appear to be in the mood to save, pushing banks to experiment with new products that provide more safety than stock-oriented retirement plan, but more upside than traditional passbook savings accounts, analysts say.

Finally, healthy small and regional banks will benefit as the industry continues to shrink.
Analysts say bank closures will continue and reduce competition in some geographic areas.
(For graphics showing the number of U.S. banks and the number of problem banks, click here
and here.)

“In the next few years, you’ll see the biggest banks and bank holding companies brought to heel both by market forces and the need for stricter regulation,” says Ed Mierzwinski, consumer program director for U.S. Public Interest Research Group, an organization that advocates for consumers.

“You’ll still see a variety of smaller and regional institutions spurring innovation, but I doubt you’ll see these big dinosaurs getting bigger,” he says.

RELATED NEWS
* Financial reforms stalled as U.S. Congress returns

* US panel to probe, tell tale of financial crisis

* FACTBOX-Major US financial regulation intiatives
* Also, Reuters will publish a package of stories to mark the first anniversary on Sept. 15 of the bankruptcy of Lehman Brothers.

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