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The Banking Regulation Punchbowl

For years, the banking metaphor of choice involved alcohol, with all of its attendant highs and lows.

For years, the banking metaphor of choice involved alcohol, with all of its attendant highs and lows. (Here are the results of a Google search for “banking” and “punch bowl,” which yielded 85,000 results.)

The new ‘Global Banking Experience’ is all about sobriety, though. The Basel III global banking regulations will boost capital requirements and call for banks to fund long-term obligations with long-term debt, instead of rolling-over cheap short-term paper. Regulations in the U.S., Germany and possibly the entire EC will force banks, not taxpayers, to take the hit if financial institutions fail in the future. And the Dodd-Frank financial reform law in the U.S. has barred banks from profitable practices such as proprietary trading.

“Policmakers are trying to make the banking system more stable and less cyclical, which is laudable,” says Andrew Fraser, investment director for fixed interest at Standard Life Investments, the Edinburgh, Scotland-based investment company with 177.5 billion euros ($242 billion) under management.

Kicking a high-inducing habit is difficult work and it has its costs. Fraser warns that the new regulatory regime will raise the cost of bank funding, reduce profits and quite possibly lead to higher costs for customers.

Bank funding costs, which already are higher than those of corporate borrowers, may rise even more before they fall. Financial companies are paying a premium of about 60 basis points compared to corporate issuers, based on data in the credit default swap market, which is a form of insurance against default, according to Fraser.

The cost of issuing bank debt will rise because of the sheer volume of debt that will hit the market. Financial debt accounts for $3 trillion, or about half of the Merrill Lynch Global Corporate Index. Bank funding requirements for this year could be in the $1 trillion range.

“Yields on new financial debt will be wider than financial debt has been in the past, and it will take years for the spread between corporate and financial debt to narrow,” he says. Why is that the case? The biggest factor is the move to force banks — and their bondholders — to take a hit if a major financial institution fails.

“Overall, banks will be safer. But when banks do get into trouble, the principal of senior, unsecured creditors could be impaired. So far, that has not happened, with the exception of a few isolated cases such as Iceland,” Fraser says.

Higher capital costs and the loss of profitable markets such as proprietary trading will put pressure on banks’ return on equity, which Fraser expects to drop to the 10 to 15 percent range from the 15 to 20 percent range.

The new era in banking will seem less like an alcohol-fueled party. As the highs and lows even out in a less cyclical era, Prozac may be a better metaphor. That’s not necessarily a bad thing. Fraser says he is “overweight” on banks. A more stable environment favors creditors.

Equity investors — whose returns are driven by profits and who often benefit from volatility —may have a tougher time adjusting to the post-party era.

For the complete II Magazine article, please click here.

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