Big global banks would seem to have clear sailing ahead now after a series of announcements made this week resolved some lingering mortgage issues and removed, at least from the near-term picture, what could have become costly new regulatory requirements. But it’s worth considering that another piece of good news for the big banks may also have added a new set of risks to the equation.
In no particular order, here is what banks are able to celebrate. First, 10 banks agreed to an $8.5 billion settlement that will put an end to regulators’ allegations that they didn’t follow proper foreclosure procedures. While that may sound like a lot of money, don’t worry; the banks aren’t likely to be hurt by the requirement to make restitution to millions of homeowners. JPMorgan Chase (NYSE: JPM), for example, has reported total net income of about $65 billion over the last five years (from 2007 to 2011), and its interest income has ranged from $61 billion to $71 billion a year in that period.
Bank of America (NYSE: BAC), which signed on to the foreclosure deal, also agreed to a separate $11.6 billion settlement with Fannie Mae over problematic mortgages. The bank agreed to pay $3.6 billion in cash to the government-controlled mortgage finance giant and to buy back $6.75 billion worth of loans it and Countrywide Financial, which it bought in 2008, had sold to Fannie Mae. It will also pay $1.3 billion to compensate Fannie Mae for loan servicing fees.
These agreements almost certainly are not the last that the banks will reach with regulators and others over the mortgage lending abuses of the beginning of the last decade. And the banks are still operating in “repair mode,” especially those like Bank of America and Citigroup (NYSE: C), that came the closest to toppling over the precipice at the height of the crisis in September 2008. As more and more of these agreements are struck, the shadows that make it difficult for investors to calculate the value of these franchises will begin to clear.
Adding to the banks’ bonanza, it seems at first glance as if the decision over the weekend by the Basel Committee on Banking Supervision to postpone the full implementation of new liquidity standards required of lenders is a big love letter to the banks. In many ways it is. The Liquidity Coverage Ratio is designed to prevent a repeat of the events of 2008, when banks discovered – to their panic – that they couldn’t readily sell assets to meet de facto runs at the height of the crisis. The goal of the new ratio, set in place by this global panel of overseers, is to ensure that doesn’t happen again by requiring that the banks have enough readily saleable assets on hand to match against the extent to which their assets are a “flight risk.” Banks would be required to have enough readily sellable assets on hand to cope with outflows that last for 30 days.
The original plan was for banks to toe this line by 2015, even though it would have required raising more than $2 trillion of new capital. That’s a tall order, as Europe struggles to avoid widespread recession and regulators fret about the anemic, fragile pattern of economic growth in the U.S. What would happen if the need for new capital causes banks to rein in lending and starves the economies of these regions of funds businesses require for expansion? That is a case that banks have carefully laid out when lobbying against new regulations of various kinds, and clearly it has fallen on receptive ears. The revised plan now calls for the requirements to be phased in more gradually, delaying full implementation by another four years and requiring only 60 percent of it to be in place by 2015.
But the Basel Committee made another concession to the banks, allowing them to count not only cash and government debt securities toward that liquidity cushion but also other kinds of assets that aren’t always very liquid in times of crises: some stocks, lower-rated corporate debt and yes, even residential mortgage-backed securities. Those will now count toward the Liquidity Coverage Ratio, albeit to a maximum of 15 percent of the total.
That’s a potential problem – another sign of the weakening level of commitment on the part of global regulators to the question of reform more than four years after the financial system narrowly avoided a complete global meltdown. True, the compromise may have been driven by fears about banks being able to meet the needs of economies struggling to grow, but it’s a risky quid pro quo. In a few years’ time, odds are that these economies will have battled their way back to stronger growth. The new and more liberal guidelines on what represents “liquid” assets on bank balance sheets, however, are here to stay.
Investors will want to hope that the market rapidly begins to distinguish between banks that take advantage of this more relaxed policy in hopes of boosting shorter-term profits and those that move more rapidly to implement the new liquidity guidelines – not just according to the letter but to the spirit of the rules. If a bank is able to generate higher profits simply because it is skimping on this liquidity measure, those earnings can’t be seen as being as sustainable on a risk-adjusted basis. They should be awarded a discount in the market.
It isn’t even as if banks can guarantee that in return for this concession they will be able to fuel economic growth via lending. It isn’t up to the banks to shape demand for capital; their obligation is only to serve as a gatekeeper and to strive to avoid making foolish loans. They can’t prod a company to expand simply because it would be good for the bank and for the economy. The company has to perceive that it can increase its profits by hiring new people, expanding its geographic range of operations or investing in new products.
These moves make for great headlines for the banks, and will probably help those like Bank of America and Citigroup, which have experienced the biggest gains over the last 12 months, as they try to return to an even pattern of profit generation. But investors will need to continue to look past the rhetoric and even the numbers in search of the banks with the most aggressive approach to managing risk.