Are Big Banks Becoming Utilities?

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Earlier this week, Federal Reserve officials unanimously voted to adopt Basel III capital rules for U.S. banks. Effective Jan. 1, 2014, U.S. banks will have to hold more capital. However, the Fed is looking to go a step further by introducing more measures to strengthen the U.S. banking system. If the Fed goes ahead with its plans, then the move could have major implications for big U.S. banks such as Bank of America (NYSE: BAC), Citigroup (NYSE: C), and JPMorgan Chase (NYSE: JPM).

Given the increasing regulatory requirements for big banks, the question is whether they will become more like heavily regulated utilities, which have lower risk profiles, but also lower growth opportunities. Before answering that question, let's look at what Basel III is all about.

What is Basel III?

To prevent a repeat of the financial crisis of 2008, global regulators have worked to make the financial system safer. Regulators believe that this could be achieved by introducing stringent capital requirements for banks and reducing leverage in the financial system -- hence the introduction of Basel III.

Members of the Basel Committee on Banking Supervision reached an agreement in September 2010 to impose new rules that would strengthen banks’ balance sheet and avert a crisis like the one seen in 2008. The new set of rules, collectively called Basel III, will require banks to hold common equity tier 1 capital equivalent to 7% of their risk-weighted assets phased in over five years.

Tier 1 capital is a bank’s core capital, and includes equity capital and disclosed reserves. The idea behind the new capital requirement is that if any bank suffers significant losses in the future, it would have the ability to absorb those losses without having a major impact on the global financial system. For instance, when last year JP Morgan suffered huge trading losses, the bank had sufficient tier 1 capital on its balance sheet to absorb the $2 billion loss it suffered. The whole event did not have any major impact on the global financial system.

It may be recalled that during the financial crisis of 2008/2009, several banks that initially said they were well-capitalized ended up asking for a bailout from the government. With this in mind, Basel III also imposes a leverage ratio under which banks will have to hold loss-absorbing capital equal to 3% of total assets. The leverage ratio is a more simple measure, and will prevent banks from finding ways to get around risk-based capital requirements. In other words, the 3% leverage ratio has been designed to ensure that banks do not buildup excessive debt on their balance sheet.

The Federal Reserve wants tougher rules for big banks

The Federal Reserve is apparently planning to implement four new rules that would go beyond Basel III.

One of the rules will be related to the leverage ratio. Daniel Tarullo, who is in charge of regulation at the Fed, told Reuters that the Basel III leverage ratio seems to have been set too low to be an effective counterpart to the risk-weighted capital measures that have been agreed to internationally.

The Fed is planning to double the required minimum leverage ratio for the biggest banks. If implemented, it would certainly make big banks more robust but investors fear that the cost of stability would be lower profitability.

Big banks already meet Basel III capital requirements

Most big banks in the U.S. already meet the stricter new capital requirements. At the end of the first quarter of 2013, Bank of America’s Tier 1 common capital ratio on a Basel III fully phased-in basis was estimated at 9.42%. Citigroup’s estimated Basel III Tier common capital ratio at the end of the first quarter of 2013 was 9.30%. JP Morgan’s was 8.9%.

In addition, most large U.S. banks meet the leverage ratio requirements set under Basel III. However, if the Fed raises the leverage ratio requirements for big banks, some of them may have to reduce their assets.

So are big banks turning into utilities?

Not really. Even if the Fed’s 6% leverage ratio requirement is implemented, big banks will still remain highly geared. In fact, major U.S. banks already have leverage ratios close to what the Fed is planning to implement. Nonetheless, banks have been generating decent returns on equity and earnings growth.

In the first quarter of 2013, Bank of America’s net income stood at $2.6 billion, or $0.20 per share, compared to $653 million, or $0.03 per share reported for the same period in the previous year.

At Citi, net income in the first quarter of 2013 was $3.8 billion, or $1.23 per share, up from $2.9 billion, or $0.95 per share reported for the same period in the previous year.

JP Morgan, meanwhile, registered net income of $6.5 billion in the first quarter of 2013, which was a record. 

With the implementation of new capital rules, the days of high return on equity at banks like the one seen prior to the crisis are probably over. However, the banking business model prior to the crisis was unsustainable anyways. The new capital rules have made the banking system more robust, and made big banks a more attractive proposition.

Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America, Citigroup Inc , and JPMorgan Chase & Co.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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