By: Gary Smith
With the Senate passing its financial regulatory reform bill on May 20th, analysts are beginning to gauge how financial sector stocks are likely to respond. The legislation creates a process for liquidating financial institutions that become too big to fail, adds restrictions to derivative and proprietary trading desks in U.S. banks, creates an agency that has the power to ban lending that the Fed considers abusive, and requires borrowers to show proof that they can pay mortgage loans. The bill fails to address the issue of the role credit rating agencies played in the recent crisis. The rating agencies were not only incompetent before and during the crisis, but also had significant conflicts of interest. Rating agencies are paid by banks, giving banks the incentive to use the agency that will provide them with the most favorable rating. The bill passed by the senate will require rating agencies to register with the Securities and Exchange Commission, but many people believe this is not sufficient. Other suggestions include making the rating agencies government-run or letting the S.E.C. decide on which rating agency is used. Without explicitly addressing the problems with the rating agencies that led to the crisis, this bill will stop short of altering the status quo within the financial community. While some believe that regulation will help large banks stabilize earnings and not hurt the entire sector, others think the legislation could significantly reduce industry profitability.
The bullish outlook for the financial sector is predicated on the belief that strict regulation has already been priced into the big bank stocks. An analyst from Keefe, Bruyette & Woods commented, “We continue to believe that passage has largely been discounted in the share value of the large banks.” In addition, the passage of a final bill could alleviate any uncertainty about the regulation creating a “relief rally.” Others believe the way banks do business will be largely unchanged by the final bill. An excerpt from a New York Times mock letter from Wall Street lobbyists to executives articulates this idea:
“In the next few weeks, however, ill-informed senators will meet with ill-paid representatives to reconcile their ill-conceived financial reform bills. This process cannot and should not be stopped. The American people require at least the illusion of change. But it can be rendered harmless to our interests. . .
To this point, we have succeeded in keeping the public focused on the single issue that will have very little effect on how we do business: the quest to prevent taxpayer money from ever again being used to (as they put it) ‘bail out Wall Street.’” (http://www.nytimes.com/2010/05/30/opinion/30lewis.html?pagewanted=1)
Still, others do not share the same optimistic stance. Meredith Whitney believes the U.S. banks have serious exposure to another dip in consumer-credit markets, “For the consumer, nothing has changed and the large banks are still weighed down by exposure to consumers. If consumer credit turns, which we think it will, you will underperform with all these banks.” New York University professor Nouriel Roubini wrote on his website that the U.S. has yet to deal with the “vulnerabilities and imbalances” that created the initial credit crisis, leaving banks in a tough position. Some analysts predict that the new derivatives regulation and the Volcker rule will reduce sector profitability, hurting financial sector stock valuations. We are focusing on stocks like WFC and BK that will be least affected by the regulation because they are less involved in derivatives and trading. Those seeking to avoid exposure to large banks should look to regional bank ETF’s such as the iShares Dow Jones U.S. Regional Banks Index Fund (IAT) and the KBW Regional Banking ETF (KRE).
The next step in the process is to reconcile the Senate bill with the House bill. There are several important distinctions between the House and Senate bills. Most notably, the Senate bill includes the Volcker Rule which restricts banks from operating proprietary trading desks. The inclusion of the Volcker rule would hurt large banks like Goldman Sachs whose proprietary trading represents a substantial portion of their profits. The bill also prevents banks from trading derivatives and requires a larger share of derivatives to pass clearinghouses and trade on exchanges. There is still a great deal of uncertainty revolving around the regulation, making it difficult to predict the impact on financial sector stocks. As the legislation progresses there will be more clarity about what the final bill will entail, allowing for more informed predictions on the implications for financial sector stocks. However, given the ineptitude of our regulatory system up to this point, it is hard to envision a final bill that would represent significant deviation from the status quo. Even despite many of the hurdles still facing the US economy and financial system, an impotent bill would certainly make financial stocks a good value at current depressed price levels.
