Bright prospects for financial stocks amid the regulatory upheavals

Financial stocks have been on a roller coaster in recent years. They were the biggest losers in the credit crunch but bounced back stronger. Sotiris Boutsis asks what';s next for investors?

Financial stocks have been on a roller coaster in recent years. They were the biggest losers in the credit crunch, but bounced back strongest of all. What’s next for investors?

My belief is that the recovery in banks will eventually be a multi-year affair as there is much scope for banks to restore their balance sheets, despite concerns over new financial regulations and possible sovereign debt contagion.

Increased regulation is a given after a financial crisis. In recent months, investors fretted that tough legislation on the financial sector would limit future profitability.

This, combined with concerns over contagion from sovereign bond holdings, has meant that banks, especially European banks, have struggled in recent months.

That bank profits will be smaller in future compared with the past decade is a certainty. This, however, is largely discounted in share prices.

Bankers are now lobbying governments hard to lessen the magnitude of the impact of new regulations. And they have won significant concessions. The news from the US and the G20 was a welcome boost for an under-fire sector.

In the US, the most controversial elements of the new financial legislation bill that President Barack Obama had steered through Congress mid July — the Volcker rule and the Lincoln amendment — were approved in diluted form.

The Volcker rule, so called because it is championed by former Federal Reserve chairman Paul Volcker, stops deposit-taking banks from proprietary trading — making money on their account.

There have been many debates and Congressional hearings over conflicts of interest, many of which involved Goldman Sachs, which appeared to benefit from shorting of the US housing market at a time when most of its clients were on the other, much more painful, side of the trade.

Some analysts argue that while the rule is well intentioned, it could still run aground due to the complex task of defining what among banks’ trading operations is truly ‘proprietary’.

The Lincoln amendment was designed to force banks to spin off their derivatives swaps desks, which were identified as a source of systemic financial risk by authorities.

However, here too, bankers appeared to have achieved concessions.

Banks such as JP Morgan Chase, Citigroup and Bank of America will be allowed to retain significant parts of their derivative units — including interest-rate swaps and investment-grade credit-default swaps.

Only derivatives based on equities, commodities and junk-rated credit-default swaps will have to be placed in a separate subsidiary with higher capital requirements.

Regulating derivatives and capital

Derivatives have been vilified in almost every country that suffered in the financial crisis. The US legislation seeks more regulatory oversight of what has traditionally been an opaque area of the financial system.

We are likely to see some forms of derivatives standardised, cleared and traded on electronic platforms.

This may create significant opportunities for exchanges, clearing houses and inter-broker dealers thanks to the incremental business from these new regulations.

Critics argue, that despite rounds of capital raisings by banks, legislation so far has failed to address one of the most critical issues that caused the crisis — leverage.

The solution to the leverage problem is to raise capital requirements. Individual countries, however, do not want to put their banks at a competitive disadvantage by imposing harsher capital requirements than those faced by their international competitors. The incidence of levies is a further complication.

While moves to create an international bank levy have faltered, countries such as the US, UK, France and Germany have made a commitment to tax the balance sheets of banks.

At the G20 summit in Canada in June, world leaders met to find broad agreement on the task of setting higher capital requirements under Basel III.

While a broad agreement on tougher regulations was reached, with reserve requirements likely to at least double, the timing of the implementation was delayed.

Obama has been vocal in saying that countries should be careful not to endanger growth by implementing unnecessary austerity measures.

Given the demands on bank capital from regulatory requirements and levies, the Bank of England emphasised the importance of capital buffers being raised gradually, to avoid choking off economic recovery.

An immediate increase in capital buffers might come at the expense of a reduction in lending.

Lending has been anaemic so far in the recovery, but this is not unusual after a financial crisis. The prolonged time scale on stricter capital controls is a good thing in this regard.

If authorities can achieve the right regulatory and taxation balance, and the global economic recovery lasts, we should see bank lending expand as economic and regulatory uncertainty recedes in the coming months.

Bank shares, then, are likely to revalue as soon as regulatory uncertainty recedes and the clouds over the economic growth outlook disappear.

Given the reasonable long-term outlook for the banking sector, there is an argument to be made for investing now at attractive valuation levels, with the prospect of a re-rating to come.

Sotiris Boutsis is portfolio manager of UK-based Fidelity Global Financial Services Fund.