Tuesday, March 17th, 2015

Masters of the Universe

The Fed’s review of the capital plans of the US banking system was a non-event. No mainstream US bank was prevented from doing what it wanted – the second time around at any rate. Some European banks were told that their US subsidiaries needed more capital and some US banks were told to improve their risk controls. But this really misses the point. The fact is that organisations which were previously regarded as Masters of the Universe were required to ask permission to pay money to their shareholders.

The reason is the complexity of their business and the geographical reach of their networks. Regulators round the world, but particularly the Fed, have decided that systemically important financial institutions (SIFIs) are the principal channel of contagion for all financial shocks and they want them to be (a) better prepared at the intellectual level (b) better capitalised at all levels (local subsidiary and group holding company) and (c) easier to break up if it all goes wrong.

The principal way of ensuring that this happens is to demand that SIFIs set aside a higher proportion of their capital to cover the contingent costs of their higher connectivity. Until recently investors have thought that this was mainly a prudential measure, but Janet Yellen’s testimony to the Senate last week makes it clear that this is the chosen instrument for forcing a break-up of the large banks. The killer quote is as follows “We’re beginning to see discussions that these capital charges are sufficiently large that it’s causing those firms to think seriously about whether or not they should spin off some of their enterprises to reduce their systemic footprint. Frankly, that’s exactly what we want to see happen.”

In other words, the Fed will continue to raise the capital requirements until there are a greater number of smaller and more specialised banks in the US, and in any other financial market or economy which could have a material adverse impact on the US.

We think this is the single most important reason why the Financials sector is ranked #6, #7 or #8 in all of our regional sector models, from the US to the UK and from Japan to the Eurozone. These regions cover a wide range of monetary policy regimes from imminent tightening to dramatic loosening and the same could be said of their economic cycles. But all of their large banks are directly impacted by the Fed’s new policies and it is quite possible that their domestic regulators will adopt much of the Fed’s approach in due course. The UK is clearly on the same page.

Ordinarily we would regard this sort of structural change as an opportunity for value creation as banks focus on areas where they have a clear competitive advantage, and are able to reduce their capital requirements by reducing their complexity. In the long run this is still our base case. However in the short-term we think that the pace of regulatory tightening will run ahead of the banks’ ability to respond.

It’s all very well to say that certain businesses should be hived off into a bad bank, but someone has to supply fresh capital for this to happen and right now there are obviously more sellers of bank assets than buyers. We are also concerned that there are not many business lines where the large banks still have a clear competitive advantage once their ability to cross-subsidize the true cost of capital is removed.

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