While the Dodd-Frank financial reform law was passed by lawmakers over a year ago, no real details have been issued as to the level of bank regulation under the act. In the coming months, issues of the future profitability of banks will come into focus as lawmakers discuss reforms in capital and liquidity standards, the Volcker limits on proprietary trading, and whether banks will be forced to restructure in order to ease the process of breaking them up for regulators.
The Federal Reserve will soon issue a proposal for future capital and liquidity requirements that must be met by the nation’s larger banks. To date, liquidity requirements have been vague — good for banks, considering the most liquid assets tend to be the least profitable, but bad in case of economic conditions leading to a shortfall. Capital rules have been more clear and tough, and the Basel III agreement will require banks to hold top-quality capital equal to 7% of their risk-bearing assets, tripling current standards. Global “systemic” banks will be required to hold up to 2.5% more more capital, and another 1% surcharge if the any of the banks — expected to include JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC), Goldman Sachs (NYSE:GS), Wells Fargo (NYSE:WFC), Morgan Stanley (NYSE:MS) — become significantly bigger.
Now the Fed must decide whether to enforce even stricter rules on its banks than the Basel accord under the Dodd-Frank act. But regardless of any decision to further increase capital requirements, banks will have to being funding themselves more with equity and less with debt. And the more equity banks are required to keep in their books, the less they are able to return to shareholders. In order to remain profitable, banks may shift resources to asset management, traditional investment banking, and emerging market consumer banking.
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One rule that will come to light in the coming months is the Volcker rule, which bans banks from trading for their own profit in securities, derivatives, and other financial instruments. Banks have been as yet unsure as to what kind of trading is still permissible, and are awaiting a ruling on how trades intended to make a market for a client will be defined.
Finally, regulators will have the ability to break up any bank that “falters”, so banks will be required to make plans in the case of such an event. And if those plans are deemed unacceptable by regulators, banks could be forced to reorganize, form foreign subsidiaries, or even downsize.