Banking on a recovery

Financial stocks have been on a roller coaster in recent years. They were the biggest losers in the global financial crisis (GFC), 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, because 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 about contagion from sovereign bond holdings, has meant that banks — especially European banks — have struggled in recent months.

Bank profits will certainly be smaller than they have been in the past decade. This, however, has already been discounted in share prices. Bankers are now lobbying governments hard to reduce the magnitude of the impact of new regulations — and they have won significant concessions. The news from the US and the G20 in recent weeks has been a welcome boost for a sector under fire.

In the US, the most controversial elements of the new financial legislation bill that President Barack Obama has steered through Congress mid July — the Volker 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 engaging in proprietary trading (ie, making money on their account). There have been many debates and Congressional hearings about conflicts of interest, many of which involved Goldman Sachs, which appeared to benefit from shorting 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 appear to have achieved concessions.

Banks like 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 GFC. 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 reach broad agreement on the task of setting higher capital requirements under Basel III. While 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 timescale 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 rerating to come.

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