Financial Regulatory Forum

ANALYSIS – Shadow banks hold key to post-Basel bank profits

By Reuters Staff
January 26, 2010

By Kevin Drawbaugh

WASHINGTON, Jan 26 (Reuters) – Bank profits are set to come under serious pressure at the end of 2012 from higher global capital and liquidity standards, but just how bad it gets depends greatly on the future of the “shadow banking system”.

U.S. banking sector analysts are increasingly focused on the interplay between the setting of global capital standards and parallel efforts to bring non-bank financial institutions to heel and moderate their resurgence in credit markets.

The ability of regulators to bring “shadow banks” — investment firms, hedge funds, insurers, special investment vehicles — under a new oversight regime will help determine the pricing power banks have to raise rates on future loans.

That will be a crucial factor in the long-term profitability of banks as capital, liquidity and leverage standards, under development through the slow-moving international Basel Committee process, eventually take hold.

“Regulators hope to strike the right balance here to ensure reasonable return and reduce the shift towards a ‘shadow’ banking system exempt from the Basel standards,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics.

“Many issues requiring additional Basel work will determine the degree to which this is accomplished,” said Petrou, whose firm advises on financial regulatory policy.

The United States has yet to fully apply the existing Basel II international bank capital accord but as a member of the Group of 20 economies has pledged to beef up its capital rules in line with the Basel reforms.

Investment advisor Concept Capital said in a note the country’s biggest banks such as JP Morgan, Citibank, Bank of America and Wells Fargo will be most affected by the Basel reform.

The reforms will introduce a global cap on leverage for the first time, a step the United States, which already applies a leverage ratio on banks, had pushed for.

Basel has proposed a tougher approach, saying derivatives positions should be counted on a gross, rather than a netted basis, a step Deutsche Bank said would add billions of dollars to its leverage total in the United States.

“The Basel Committee proposal is definitely more onerous than the leverage ratio the U.S. banks adhered to, not only because of treatment of assets but also having to account for off-balance sheet assets as well,” said Andrew Lim, an analyst at the Matrix Group.

Sector analysts FBR Capital Markets said it favors regional banks that have already moved to enhance capital levels and address credit concerns, such as Fifth Third Bancorp, Huntington Bancshares, Regions Financial Corp and Zions Bancorp.

“We remain cautious on banks that have not bolstered capital levels enough … such as Synovus Financial Corp, or banks with premium valuations that do not properly reflect risk of continued residential and consumer credit pressures, such as Wells Fargo & Co,” FBR said.

As it looks increasingly likely the banks won’t be able to skirt tougher new bank capital rules, analysts are looking to what extent the shadow banking sector will be hit as well.

A report this month from an international regulators’ group known as the Joint Forum called for closing gaps in oversight of firms such as bailed-out former mega-insurer AIG and collapsed investment bank Lehman Brothers.

Both were among institutions that cut deeply into the market share of banks during the credit bubble that burst in 2007-2008, ushering in the deepest U.S. recession in decades.

The taxpayer bailouts that followed, including one for AIG, helped set in motion a global push toward tightening financial regulation. One area of agreement among policymakers is that banks should have to keep more, higher-quality and more easily liquidated capital on their books in case of trouble.

G20 TARGETS

G20 finance ministers agreed on this last year. The U.S. Treasury Department was expected to produce a draft of tougher standards by the end of 2009, but missed the deadline.

A comprehensive international agreement on standards is slated for the end of 2010 and implementation is targeted for the end of 2012, although some senior policymakers have their doubts about whether these milestones will be achieved.

Most analysts agree, however, that stricter standards for capital, liquidity and leverage are coming, and will squeeze bank income, especially in combination with other efforts to crack down on the regulatory oversight of banks globally.

As the law stands today, non-bank institutions, which don’t take deposits, don’t have to follow the same rules banks do, and that includes capital standards. The loophole gives these shadow banks a competitive edge in the credit market.

The Joint Forum report called for more consistent capital requirements across financial sectors.

“International regulators will make a strong push to both curtail shadow banks and subject them to the same capital and other requirements that banks face,” said Jaret Seiberg, policy analyst at investment advisory firm Concept Capital.

“Yet we remain skeptical that international regulators will deliver on their promises. That is why we still see the odds favoring the re-emergence of shadow banks.”

(Reporting by Kevin Drawbaugh; Editing by Ruth Pitchford) ((kevin.drawbaugh@thomsonreuters.com, +1 202 898 8390, +1 202 488 3459 (fax)))

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