The Dodd-Frank Act

Managing third-party risk in a changing regulatory environment.

May 2015 | by John Olivier, Chief Investment Officer

This autumn, many US banks reported a respectable improvement in earnings for the third quarter: more than eighty percent of the largest beat the market’s consensus forecasts, and a similar proportion showed year-on-year increases. The second quarter was equally impressive. So why have the stocks of large banks declined by more than twenty percent since the beginning of the third quarter—nearly three times more than the broader stock market—to the point where four out of five now trade below book value?

Investors want to see the management teams of banks propose credible, far-reaching plans to close this gap. The message that investors are now sending—shares of banks will be valued at levels implying that they will not earn their cost of equity—has profound implications for a US economy dependent on a healthy banking system to support recovery and fuel growth.

Of the three threats, the most significant comes from the Basel III requirements, proposed by the Basel Committee on Banking Supervision. Without mitigating actions, they could reduce the ROE of some banks by as much as five percentage points. While the details are still being determined, we estimate that the US banking system will need an additional five-hundred billion in retained earnings or new equity to meet the new capital adequacy standards (assuming the current asset level and mix).

The second threat is the continuing deleveraging of consumers. The history of the past 100 years suggests that when excessive borrowing is a principal cause of a recession, consumers and businesses spend the next seven to eight years rebuilding their balance sheets. On that basis, we are in only year three of a much longer journey. There is little prospect of a quick return to the heady consumer-borrowing levels of the years immediately preceding the crisis—and some of that business may never return. In 2006, after all, bank revenues related to consumer credit exceeded their longer-term average by twenty percent.

Third, US bank regulations resulting from the Dodd–Frank Act are also taking their toll on bank profits. The reasons include an amendment that caps fees on payments, as well as a requirement to move many over-the-counter businesses to clearing houses and to divest proprietary activities. The costs implicit in a new consumer oversight agency will probably make day-to-day operations more expensive and complex. We estimate that by remaking all three key banking businesses, the industry could boost overall ROE by five to six percentage points. But valuations won’t improve until investors have a clear understanding of the banks’ plans to embrace the new business model implicit in this transformation.

 

Executive Editor

Ms Anna Sullivan

Ms Anna Sullivan