CreditSights, the independent credit-focused research company, has issued a giant two-part report on what’s coming for US banks in 2012. Naturally, it’s credit-focused. Surprisingly, it’s also quite optimistic and suggests positive implications for jobs in Europe (in comparison to a more gloomy report also issued by JPMorgan Cazenove). Here’s what you need to know:
CreditSights’ analysts say US banks are entering their ‘post-modernist’ phase.
In this, it says banks will need to adapt to lower leverage and lower margin opportunities. Their returns will fall to the the high single digit to mid-double digit range.
Among other things, post modern banking activities will be about providing hedging products designed for risk mitigation. Think solutions.
CreditSights says problems growing revenues will create a ‘primary headwind’ for US banks in 2012.
Positive revenue momentum will be dampened by: the Volcker Rule; high capital and liquidity requirements from Basel III; margin pressure related to curve flattening due to ‘Operation Twist’; and by continued low revenues from ECM and DCM due to stressed trading conditions.
On top of all this, the earnings boost from credit quality improvement has ‘largely played out.’
Details of the Volcker Rule were announced in October 2011. The proposed date for the rule to become effective is July 21st 2012. In its putative form, CreditSights says the rule could ‘further reduce capital deployed on trading desks’ and that trading revenues could decline. However, it also points out that US banking regulators have extended the comment period for the rule from January 13th 2012 to February 13th 2012, suggesting there’s been a lot of ‘pushback’ from the industry.
The really big issue with the Volcker Rule as specified, is that US banks will only be able to generate fees from commissions and bid/ask spreads, NOT from the appreciation in value of their positions. Equally, they will not be permitted to pay traders based on the appreciation in value of financial positions, only on commissions and bid/ask spreads.
CreditSights points out that: “The 7th rule explicitly states that any trading inventory position which is to “earn profits as a result of movements in the price of positions” would not be considered market making. As well, we sense traders could be reluctant and/or restricted from, putting on positions in advance of an excepted move as this could be seen as proprietary.”
Whilst this could clearly be disastrous for traders in the US, who have been used to making revenues and getting paid on the basis of appreciating financial positions – even while merely market making – it may prove a very great thing in Europe and Asia.
This is because, as we noted back in October, the Volcker Rule as drafted allows proprietary trading as long as it takes place outside the USand doesn’t involve a US company or its subsidiaries. The draft rule also applies only to any trade directly involving” someone in the US(even if they work for a non-US bank). Any trades executed, “wholly outside,” the US will be exempt. The implication is therefore that non-US banks will move both their traders and back office staff out of the US and into Europe or Asia.
Even though banks theoretically have seven years to meet Basel III requirements, CreditSights says those that aren’t on track to meet them by 1Q13 could face restrictions related to dividend increases and share repurchases. By the end of this year, therefore, US banks will need fully phased in 7% tier 1 common capital, with additional SIFI buffers of 1-2.5% phased in over time. The good news is that most US banks are on track to meet the new rules already. Citigroup, Morgan Stanley and Goldman Sachs have: ‘above peer average regulatory capital measures.’
Despite these headwinds, CreditSights analysts are feeling optimistic. They expect a slow resolution of the eurozone crisis driven by the ECB’s liquidity programme, which they think will keep European banks liquid and return some normalcy to the markets. They also point out that the fundamentals of US banks are vastly improved and that liquidity is now 2-3 times stronger than before the initial crisis.
The US political situation and growth concerns in Asia remain wild cards, but CreditSights thinks the risk-off environment will subside as Europe stabilizes, as trading volumes recover and as M&A rebounds.
Finally, as a wild card, CrediSights analysts suggest Merrill Lynch bankers would do well to escape the clutches of BofA.
“Mortgage concerns, credit losses, and ill-timed acquisitions are all creating problems for Bank of America, leaving it in a ‘challenging position’ to meet the higher Dodd Frank and Basel III capital requirements,” they write.
By comparison, CreditSights says Merrill Lynch is a ‘superior return opportunity’ considering its, “standalone comparables and business profile.”