The Independent Market Observer

7/10/13 – Financial Services: Less Risk, Less Return?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jul 10, 2013 9:46:53 AM

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I wrote on June 11 that the financial services sector was under pressure, and the heat continues. One of the big memes floating around about the banking industry has been how nothing fundamental was really done, in the aftermath of the financial crisis, to rein in systemic risk. The Dodd-Frank Act was supposed to do so, but, the narrative went, it didn’t go far enough and had been gamed by the banks to remove the most onerous provisions.

Regardless of whether this was true—and there was enough truth there to make it plausible—the narrative has supported a continued push to rein in the biggest banks. Today, federal regulators took, to quote the Wall Street Journal, “their first big swing at addressing fears that Wall Street’s largest firms remain too risky five years after the financial crisis.”

Rather than complex formulas, which can be gamed, or prohibitions of certain activities, which can be tough to define, the feds decided this time to make it simple—and much more difficult to evade.

Banks are required to hold capital against their assets, to provide a cushion against declines in asset values. For example, a bank has to set aside capital against a loan, in case that loan goes bad. The riskier the asset, the more cushion is needed and the more capital banks have to set aside.

This seems like common sense, but the problem is that set-aside capital just sits there. It’s not making much money for the firm, and, by both increasing the required capital base and not making money, it hits bank profitability from both sides. Responsible banking is a trade-off between safety and return. Less risk, less return.

As a first step, the proposal requires banks to double the amount of capital they hold against all assets, which would dial back both the risk banks are taking and their returns. The first is the goal of the regulation; the second is what bankers are and have been fighting against. The goal of the measure, again according to the WSJ, is more or less explicitly to force big banks to either “become more conservative or to shrink.”

This could be a big hit to the banking industry, with the largest banks potentially needing to raise between $40 and $90 billion in new capital.

The argument against the proposal is that banks already adequately manage risk, and the new requirement is overkill. In fact, the argument goes, requiring banks to raise that money will make them less able to compete and could decrease overall lending and banking services, damaging the economy as a whole. Certain low-margin business lines, for example, may no longer be economic with the higher capital requirements. If lending were to decline, that would hurt the economic recovery.

The argument for the new proposal is that banks have demonstrated multiple times in the past that, in fact, they do not practice good risk management but do have a proven ability to game complex rules. By putting a simple, comprehensive risk cushion in place, the feds will hold banks accountable for operating as profitably as they can in a systemically safe way. The burden of proof would shift from the regulators to the banks. And this is only the opening shot from the regulators. Further restrictive proposals are expected in the next couple of months.

Arguably, the current proposal isn’t restrictive enough. A bipartisan bill from earlier this year, Brown-Vitter, actually included higher capital requirements. Also, unlike in the past, the industry is split, with large banks opposing the new requirement and the community bankers association supporting it. We can argue about where the new level of cushion needs to be set, but raising the current level has a lot of support.

Overall, there are a lot of things to like about the proposal. It’s simple, difficult to game, and focused where it should be—on the systemic safety of the financial system. What it will do, though, is reduce the size and profitability of many sectors of that system. Over time, this will be good for the economy as a whole, but it will probably impose short-term costs.

The proposal isn’t final, but it seems probable that this and other regulatory measures will continue to redefine the financial sector going forward, in a way that will be more restricted and less profitable than in recent decades. Investors should be aware of these trends and allocate their investments accordingly.

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