What a Stable Banking System Means for Your Banking Stock

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The U.S. banking sector is facing more and more stringent capital requirements, the latest of which is the two-fold rise in the leverage ratio minimum to 6%. While some meet the proposed requirements, others don’t. Therefore, it’s unlikely that the Fed will set a minimum leverage capital target that significantly disadvantages the U.S. banks relative to their international counterparts. Nevertheless, I don’t expect a 6% level to be a more meaningful constraint on capital return for banks in the U.S.

Proposed requirements

Bloomberg reported that the Fed and the Federal Deposit Insurance Corporation (FDIC) are aiming to raise the leverage ratio minimum to 6%, which will be twice the international banks will be required to hold under the Basel III requirements.

Unlike the Tier 1 common ratio, which is based on risk-weighted assets, the leverage ratio is based on total assets. The proposed leverage ratio will incorporate certain off-balance sheet exposures such as derivatives and commitments.

Do the banks meet the proposed requirements?

Among the large cap banks, Citigroup (NYSE: C) and Bank of America (NYSE: BAC) have the least leverage ratios of 4.6% and 5.1%, respectively. Both have over $650 billion of estimated off-balance sheet assets which add up to calculate the Basel III Tier 1 leverage ratio. In contrast, Capital One Financial (NYSE: COF) has the highest leverage ratio of 7.7% with the lowest amount of estimated off-balance sheet items ($52.7 billion). On average, the large cap banks have a 6.1% Basel III Tier 1 leverage ratio.

Under Basel I regulations, current assets like cash, Treasuries, and other assets receive a 0% risk-weighting. If these asset categories are eliminated from the calculations of total assets in the leverage ratio under the proposed regulations, Bank of America would be pushed above a 6% leverage ratio. Citigroup would be pushed to a 5.9% leverage ratio as of March 31, 2013.

What could they do to meet the proposed requirements?

Given the substantial increase in capital over the last few years, I believe the banks will engage in balance sheet management to meet the requirements. This, coupled with internally generated capital, should be sufficient to meet the proposed 6% leverage ratio target. Balance sheet management means the constraints banks put on their liquidity coverage ratio, net stable funding ratio, capital conservation buffer, and asset liabilities ratios.

Also, contrary to popular opinion, analysts at Credit Suisse see no dividend cuts by these large cap banks nor capital raising if the minimum leverage is set at 6%. Further, if the proposed leverage ratio is implemented, banks like Citigroup and Bank of America, that fall short, would need to reduce their assets, including their off-balance sheet assets, by 17% on average.

Among other ways for Citigroup and Bank of America to cope with the proposed leverage ratio standards include suspension of their dividends. One consequence of the proposed regulations might include lower earnings potential for Bank of America and Citigroup as banks continue to raise internal capital. While banking stocks are not famous for their dividend yields, they still form part of the total returns.

Bank of America offers a dividend yield of 0.31% on its quarterly dividend rate of $0.01 per common share. Citigroup has a similar dividend rate and yields 0.08%, while Capital One Financial offers a dividend yield of 1.9% on its dividend rate of $0.30 per common share. Since Capital One already meets the requirements, suspension of its dividend is highly unlikely.

Conclusion

Given the substantial increase in capital over the last few years, larger banks in the U.S. are expected to pursue balance sheet optimization to meet new leverage requirements. Further, it’s believed that banks will not cut their dividends and nor will they raise more capital to meet proposed requirements. That said, I believe the Fed will not introduce regulations that will be disadvantageous to the U.S. banks.

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Red Chip has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America and Citigroup Inc . 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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