Talking Point: Restoring American financial stability

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over the past few months. As a result, the short-term implications of the new regulations for the US banking industry will be muted, and the longer-term implications should result in a more stable banking and financial system.

That said, the complexity of the new regulations will present a challenge for many financial organisations and, in analysing the legislation, it is clear that the changes will produce both winners and losers among the key players in the industry. As a result, issuer selection will be increasingly important in building bond portfolios going forward, as the new rules substantially increase the likelihood that bondholders will bear some of the potential losses during the next (inevitable) credit downturn.

Schroders’ fixed income investment strategy for US financial institutions has been biased towards owning large financial companies with significant funding advantages and diverse, robust earnings capabilities. As we move into a new regulatory environment, we do not expect to make significant changes to our current strategy as many of the new reforms will be implemented over a longer time period. Furthermore, we do not think the regulation should threaten the fundamental qualities of the firms we find attractive, even though they will likely impede profitability. Below we outline the major points of the new legislation, along with our view on the possible effects for the banking industry.

Dissolution (Resolution) Authority

The primary objectives of this section of the legislation are first, to expand participation across the capital structure in the event of a firm’s dissolution, and second, to remove systemic support from the industry, effectively eliminating the notion of ‘too big to fail’.

We believe this is the most important part of the legislation. Dissolution Authority introduces participation across the capital structure should a large financial institution reach the point of insolvency. Given the levered nature of a bank’s balance sheet and US depositor preference (bank depositors are ranked above senior unsecured bondholders), recoveries from a dissolved institution – even at the senior debt level – will likely be significantly impaired.

Along these lines, the credit rating agencies (Moody’s and S&P) have indicated that bank holding companies could be at risk of losing their A-1/P-1 ratings as they revisit their bank support rating methodologies. We view the downgrade potential as fairly high given the amount of ratings uplift, (historically based on assumptions of systemic support for large, interconnected financial institutions) that the agencies included in their ratings. Nevertheless, the repercussions should be manageable, especially because many of the firms that would be affected have the financial flexibility to either shift their respective funding needs or continue to reduce their funding requirements by shrinking loan portfolios further.

The Dissolution Authority regulation also introduces loss sharing for secured creditors (generally trade-related counterparties) of up to 10% for all transactions less than 30 days. We expect this to have a negative effect on repurchase markets, and it will further emphasize the need for careful security selection on both a debt and counterparty level.

Derivatives Regulation

This part of the legislation is designed to prevent bank subsidiaries from engaging in trading derivatives, and to add transparency to the overall derivatives markets. It requires that interest rate swaps, credit default swaps, and other related instruments be traded on public exchanges. Futures contracts are excluded from this provision, and foreign exchange-related derivatives may be excluded by the US Treasury.

This move will reduce profits at the largest derivatives traders (JPMorgan, Goldman Sachs, Citigroup) and will force banks to establish separately capitalised, non-bank subsidiaries to trade specialised derivative contracts (metals, energy and so on). While the exact timeline for these changes is still to be determined, we believe that the derivatives regulations will have negative implications in the long term. In particular, we will be watching to see how the newly established non-bank subsidiaries are accepted by the market and how effectively they compete with foreign banks that are not subject to this law.

Volcker Rule

The Volcker Rule was initially designed to prohibit banks, their affiliates and bank holding companies from proprietary trading, and investing in or sponsoring hedge funds and private equity funds. It also sought to limit relationships with hedge funds and private equity funds more generally.

In a coup for the banks, the provision that was passed is actually a heavily watered-down version of the original. The provision merely caps investments in hedge funds and private equity funds at 3% of Tier 1 equity, and restricts a bank’s ownership in any one fund to 3% of that fund’s assets.

Implementation is not expected until 2012, with a three-year window for divestiture of illiquid holdings. As such, the immediate impact to bank credit fundamentals will be minimal, with similarly limited implications in the long run. In fact, since few banks currently invest more than 3% of their Tier 1 capital in these vehicles, we could actually see these investments ramped up to replace lost revenue in other areas.

Financial Stability Oversight Council

The sole responsibility of the 10-member Financial Stability Oversight Council is to identify and respond to emerging risks throughout the financial system. The Council will be chaired by the Treasury Secretary, and will be comprised of the heads of the Federal Reserve and Securities and Exchange Commission, as well as other regulatory bodies.

We view the creation of this additional oversight panel as neutral for the banking industry in the short term, and slightly positive longer term. The establishment of a centralised team should allow the US to identify and react more swiftly to mitigate potential financial bubbles.

Capital Requirements

Introduced late in the legislative process, this section will increase both the amount and quality of capital that large financial institutions (those with over $15 billion in assets) are required to maintain.

We view this as having positive implications for bond investors, especially if higher levels of capital are coupled with better liquidity. The phasing out of debt-like equity securities also preserves capital for rainy days – at least to the extent that bank management teams do not divert capital into capital destroying investments in search of yield.

Consumer Financial Protection Bureau

The legislation establishes a new regulator that will focus exclusively on consumer-related lending issues. From a political perspective, this will be viewed as a victory for consumers, but in reality, it may have unintended consequences that could constrain economic recovery. For banks, the decreased profitability of consumer lending may lead them to further restrict the flow of credit, and, when combined with other recent regulation that reduces bank fees, management teams may seek riskier activities to meet their return targets. As a result, we believe this element has negative implications for the industry.

Federal Reserve Audits and Independence

This legislation allows the Federal Reserve to retain its independence, but will subject the Fed to a review of its actions during the financial crisis. It also requires the Fed to disclose open market operations and discount window transactions with a two-year lag. This increases transparency and accountability, while still maintaining the Fed’s critical role as a lender of last resort for the stability of the financial system.

The independence of the Fed creates an environment that is conducive to lower and more stable long-term rates since there is less political pressure to potentially monetise public debt in the years ahead. The Fed may still choose to do so in times of stress, but if it does, it will be for economic reasons and will be at the Fed’s discretion, rather than as a funding mechanism tied to political manoeuvres or policies. Overall, we view this as a positive outcome for the banking industry.

The bark was worse than the bite

On consideration of all the complicated provisions contained in this legislation, we conclude that much of the bite has been taken out of the final version, and, for the most part, the market has already priced the diminished impact into spread levels. As such, we are not likely to change our investment strategy towards financial companies, and will continue to favour large, diversified depository institutions that we consider attractive given their exceptional liquidity, capital levels and valuations.

Additionally, there is nothing tangible in the reform that would change our cautious view on the majority of the regional bank issuers. Most of these credits continue to have large exposure to commercial real estate, which we believe restricts their potential for financial improvement and performance.

That said, the new regulatory environment does mean that investors need to view the financial sector with more scrutiny than before. Indeed, detailed credit and capital structure analysis will become even more critical over the next year or more as these reforms are implemented in the industry.

The views and opinions contained herein are those of Harold Thomas, Fixed Income Analyst: US financial sector, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.

For professional investors and advisors only. This document is not suitable for retail clients.

Source: ETFWorld – Schroders