Earlier this week, the regulators published the new Basel III rules for the U.S. banks. While some standards were left unchanged, others were changed to better suit the relatively smaller banks. However, Bloomberg reports that the regulators are now gearing up to introduce much more stringent rules for the large cap banks. Particularly, JPMorgan Chase & Co. (NYSE:JPM), Wells Fargo & Co (NYSE:WFC), and Goldman Sachs Group Inc (NYSE:GS) are poised to face rules that are even more stringent than the newly published Basel III regulations.
The discrimination
It seems that the regulators are willing to give some leverage to the relatively smaller banks as I noted the relaxations given to the non-advanced banks when the new Basel III rules were published. In contrast, the regulators are in no mood to spare the large cap banks. I believe this discrimination is important in setting new capital regulations because there is a considerable difference in the sizes of the largest six banks compared to smaller banks.
More stringent rules than Basel III
The regulators are consulting to set a minimum ratio of capital to assets that exceed the 3% floor set under the final Basel III regulations. Expectations are that this ratio may be doubled in order to make the large banks safer. Another measure might force the large cap banks to hold a minimum amount of equity and long-term debt to help the authorities dismantle defaulting lenders. Further, banks that rely on short-term (wholesale funding) might be required to hold additional capital.
Risk weighted vs capital regardless of risk
After the financial crisis, the regulators became doubtful about the complex formulas behind those risk weights. The 2008 crisis also gave rise to a debate whether the risk weightings should be continued to be used as a risk control measure. The regulators are increasingly demanding a minimum capital against assets, regardless of the assets’ perceived risk. It is believed that the risk weightings can easily be manipulated.
Eroding profits
An obvious consequence of the stringent capital requirements on the large banks will be a hindrance in their lending abilities. Since the large banks will be required to hold more capital, less capital would be available for lending purposes. When the banks’ lending abilities are hurt, you should expect profit erosion and even shareholder distribution suspensions.
The Fed closely monitors shareholder distributions including share buybacks and dividends for the U.S. banks. JPMorgan Chase & Co. (NYSE:JPM) currently offers a quarterly dividend rate of $0.38 per share and yields 2.90%. Further, the bank has been authorized to buyback $15 billion worth of its own common shares. So, the combined shareholder distributions form a significant part of the total returns.
Wells Fargo & Co (NYSE:WFC) yields 2.90% on its quarterly dividend of $0.30 per common share. Both its quarterly dividend rate and the shareholder buybacks increased recently. In comparison, Goldman Sachs Group Inc (NYSE:GS) offers a dividend yield of 1.30% on its quarterly dividend rate of $0.50 per common share. Further, Goldman Sachs Group Inc (NYSE:GS) decided to reward shareholders by buying 75 million of its common shares.
So, these shareholder distributions form an integral part of the total return these banks provide their investors, and a suspension of these distributions would mean lesser returns for investors.
Poised to benefit from rising rates
JPMorgan Chase & Co. (NYSE:JPM), the largest bank by assets, is all set to benefit from the prevailing rising interest rates. The bank’s CEO was reported saying that JPMorgan Chase & Co. (NYSE:JPM) could make an additional $2 billion if the yield on the 10-year Treasury climbs 100 bps. Investors should expect this amount to touch $5 billion if the yield climbs 300 bps. Besides, it is well positioned to grow its book value despite the rising rates. According to Credit Suisse estimates, JPMorgan Chase & Co. (NYSE:JPM) will report a 1.1% growth in its book value at the end of the second quarter.
Rising rates to hit book value
Wells Fargo & Co (NYSE:WFC) remains one of the least preferred large cap banks as far as its book value growth is concerned amid the prevailing interest rate environment. Its tangible book value is expected to plunge the highest (5%) if the rates go up 100 bps. However, its CFO was reported as saying the bank’s earnings potential would be enhanced if the rates continued to increase.
Higher hopes
For Goldman Sachs Group Inc (NYSE:GS), Citigroup’s analyst believes that a tough June has erased optimism about the strong start to the second quarter. The analyst also believes that Goldman Sachs Group Inc (NYSE:GS) will miss its estimate as the bank’s lending and investing portfolios got hurt due to the recent correction in the risk assets. However, one positive stock price driver for the bank will be that the rising interest rates are signaling a rebounding U.S. economy and not just fears about the unwinding of the QE. Economic recovery could lead to increased capital market activity, which would benefit Goldman Sachs Group Inc (NYSE:GS).
Conclusion
I believe the size-based discrimination by the regulators when it comes to setting the capital regulations for banks is a step in the right direction. The large banks need to be tamed and made safer, while the smaller ones need to be given a push. However, too stringent capital regulations for the large banks will also lead them to report lower earnings and possible shareholder distribution suspensions. Therefore, the regulators must be cautious with the trade-off. I believe JPMorgan Chase & Co. (NYSE:JPM) is best positioned for the current and proposed capital regulations and the interest rate environment.
The article More Stringent Rules for Large Banks originally appeared on Fool.com and is written by Adnan Khan.
Adnan Khan has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs and Wells Fargo. The Motley Fool owns shares of JPMorgan Chase & Co (NYSE:JPM). and Wells Fargo. Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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