It is difficult to imagine a more positive environment for US banks than that which opened 2018.
Consider the performance of bank shares on the US stock exchange. The KBW Nasdaq Index, which covers 34 commercial banks, has rallied over the past two years to just 12% below its record level of February 2007.
What underpins the surging valuations?
For a start, president Donald Trump’s $1500bn tax overhaul, passed in December by the Republican-controlled Congress, is a very, very big deal for banks because they typically pay higher effective tax rates than practically any other US industry.
Analysts at a Goldman Sachs conference in New York in December estimated that the measure, which includes a cut in the general corporate tax rate from 35% to 21% and took effect on January 1, would increase large bank profits by as much as 13% in 2018.
New faces
A further boost for US banks comes in the shape of the arrival of new Trump administration appointees at the head of the country’s various capital market and banking regulatory bodies. These include Randal Quarles, a former government official, who previously gave banks legal advice and invested in them. As the Federal Reserve’s vice-chairman for supervision, he is considered the most influential US financial regulator.
Other appointments to the Federal Reserve’s board, which has several vacancies, are expected imminently, though Jerome Powell, a former private equity executive and the only non-economist to be named Federal Reserve chairman in more than 40 years, is expected to soon take over as the US central bank’s chairman when Janet Yellen, who was appointed by former president Barack Obama, steps down in February.
This slew of new appointments has brought a change in the tone of government officials and financial regulators that is more conciliatory towards banks, and more pro-business and market oriented. Noticeably, the Department of the Treasury, under secretary Steven Mnuchin – who worked on Wall Street and ran OneWest Bank, now part of the regional banking CIT Group – has issued several reports, including one in October 2017 that recommended the reappraisal of some 100 bank rules.
This regulatory easing is possible, according to bankers, because the Dodd-Frank Act, implemented after the 2008 meltdown to ensure the stability of the financial system and contain the risks of the largest, most systemic financial institutions, was largely a skeleton law. It left regulators with a tremendous amount of discretion regarding oversight and the ability to write and change regulations.
However Mr Mnuchin, Mr Powell and many of the newly appointed regulators have frequently said they are not interested in wholesale efforts to dismantle or roll back Dodd-Frank. In a prepared testimony to the Senate Banking Committee in June 2017, Mr Powell said those rules had made the financial system “substantially stronger and more stable”.
A lighter touch
Mike Lee, managing director at the Clearing House (TCH), which represents the country’s 45 largest banks, sums up the shift: “Under the Obama administration the likelihood of getting any change under Dodd-Frank was very slim. It was very resistant to opening up any part of it because it felt it would begin an erosion process. But with the new administration, officials and staff, they are more open to these changes. Going from someone who is not willing to talk about changes to someone who is, is a pretty big switch.”
There are exceptions to the lighter touch regulatory approach, however, as well as to what most consider an array of pragmatic new regulators.
Eschewing the original idea of setting up a board at the Consumer Financial Protection Bureau (CFPB) – which brought in new rules governing mortgages and credit cards and returned more than $12bn in bank fines to some 30 million customers – Mr Trump chose instead to have the bureau run by a single interim director, Mike Mulvaney. A former congressman, Mr Mulvaney led congressional criticism of the bureau’s agenda, and since his CFPB appointment he has stopped approval of payments to victims of alleged financial crimes, frozen all new rule-making and ordered a review of active investigations and lawsuits.
A matter of importance
Against this background, another development in the first year of the Trump administration is being feted as good news for medium-sized and small banks. This is a bill advanced by Mike Crapo, the Republican senator for Idaho and chairman of the Senate Banking Committee that, exceptionally in a deeply partisan Congress, already has the support of at least nine Senate Democrats, meaning it could meet the 60-vote minimum needed to clear the full Senate, with a vote possibly occurring early in 2018.
A long-awaited element of this bill is a proposal to raise the threshold at which banks are considered 'systemically important', and therefore subject to the strictest Federal Reserve supervision including full-blown annual stress tests and onerous capital and liquidity requirements, so that it does not apply to banks with between $50bn and $250bn in assets.
The legislation is a product of bipartisan support for the idea that regional and medium-sized US banks have been unfairly categorised as a risk to the financial system, or as systemically important institutions, bringing them under the same strict regulatory standards as the country's largest global banks. Highlighting the discrepancy, Utah-based Zions Bancorporation, a regional bank, has about $65bn in assets, while JPMorgan Chase, the US’s largest bank, which is highly interconnected with major investment banking and trading operations and has a global reach, has some $2560bn. Both are currently considered 'systemically important'.
Doubling up
Congress’s move has come later than many regional bankers had hoped when Mr Trump took over at the White House.
Harris Simmons, chief executive of Zions Bancorporation and apparently frustrated by the delays, seemed to pre-empt the Senate proposal and try to resolve the regulatory unfairness towards regional banks on his own. In November, he asked the Financial Stability Oversight Council, a group of senior regulators and government officials created by Dodd-Frank, to remove Zions from the list of systemically important financial institutions, so that the bank would not have to undertake the annual stress testing and meet the tough regulatory requirements of the Federal Reserve.
In an interview with The Banker, Mr Simmons says one motive for his initiative is his belief that there is no need for the bank to have two regulators.
“There is a lot of duplication,” he says. “There are examinations of the Federal Reserve that are routinely conducted. There is always something going on that it is examining and it is almost always something that the Office of the Comptroller of the Currency [which regulates nationally chartered banks] has recently examined or is about to examine. So there is an echo.”
Regional banks have also voiced their dissatisfaction with Federal Reserve stress testing, because a failure – which occurred at Zions, Citizens Financial Group, BB&T and Sun Trust Bank, for instance, in previous years – resulted in these banks not being allowed to repurchase shares, increase dividends or pursue a deal, in their view hindering the banks’ ability to serve customers and grow.
Loss of control
Brian Klock, a specialist in regional banks at New York-based financial analyst Keefe, Bruyette & Woods (KBW), says a key issue associated with the stress tests was bankers experiencing a sense of a loss of control. According to Mr Klock, the lack of decision-making power was felt not only in connection with decisions affecting the distribution of the banks’ capital and capital plans, but also in the way Federal Reserve-run stress tests used the Fed’s own macroeconomic data and loss assumptions for each category of risk, rather than the banks’ own data, stress-test processes and loss assumptions, which would then be shared with regulators.
“The biggest benefit [of the Senate’s proposal to raise regulatory thresholds] is allowing the management teams and the boards of the banks to manage their own excess capital again without having to go through this year-long process of stress testing,” says Mr Klock.
According to a KBW study, should the proposal become law, 11 regional banks would have about $23.5bn in excess capital which, by being allowed to bypass annual Federal Reserve exams, they are likely to return to shareholders. The study claims that if CIT Group, Zions, Citizens Financial Group and Comerica, the most over-capitalised banks in this group, deploy their excess capital in increased share repurchases and higher dividends, then these banks’ earnings per share over the next few years could rise by between 13% to 17%.
As it is, the shares of the four banks rose 35% in 2017 compared with a 30% rise for the 34 commercial banks in the KBW Bank Index.
M&A boost
Catherine Mealor, a KBW specialist in banks with assets of between $10bn and $50bn, says these banks also stand to gain from the proposal to lift the regulatory threshold. “It really opens up mergers and acquisitions [M&A] for companies of this size… because they are not butting up against an arbitrary $50bn threshold. They were trying to manage below this threshold before,” she says.
Bankers believe that if Trump administration regulators ease penalties and restrictions on banks, this could also be a big incentive for banks to engage in M&A.
“There are now a lot of restrictions on banks’ ability to merge if they have any supervisory problems whatsoever. I think those [restrictions] are likely to be loosened and that could have a tangible impact on banks’ M&A,” says TCH president Greg Baer.
Meanwhile, regulatory easing in relation to Federal Reserve stress tests is under way. The US central bank has dropped one of the toughest components of the exams, the so-called 'qualitative review of a bank’s risk management', for all but the country’s biggest banks, which include the US’s eight global systemically important banks. And under Mr Quarles’ supervision, the Federal Reserve has started to grant banks a number of changes they have long sought, including tilting towards giving more details of annual Fed stress tests in advance.
Small wonders
Reforms proposed in the Senate bill also bring comfort to community banks with assets of $10bn or less. Key proposals for these banks include plans to streamline mortgage rules and simplify capital requirements.
Paul Merski, vice-president of the Independent Community Bankers of America group, which claims to have thousands of community banks among its members, says that according to the new capital rule, “a small bank that has a tangible equity leverage ratio of between 8% and 10% (and that maintains a higher capital level than that ratio) would be considered a well-capitalised bank. It no longer has to deal with the complexities of Basel III’s risk-weighted and concentration capital rules.”
Lloyd Devaux, chief executive of Miami-based Sunstate Bank, believes if the simplified capital rule takes effect, there would be an increase in community bank lending to small businesses, which has been sluggish in the past few years. This is mainly because it has taken these banks so long to repair their balance sheets after the 2008 downturn, some bankers say.
“Small businesses generate most of the jobs in the US and small banks do most of the lending to small businesses,” says Mr Devaux. “So if you put a lot of [regulatory] burden on the small banks, you prevent them from doing this lending, which is detrimental to the economy.”
Risk profile
But is there a downside to the Senate bill?
One risk is possible overreach by Republicans in the House. This could happen if, for instance, Jeb Hensarling, the chairman of the House Financial Services Committee and a Texas Republican, sees it as an opportunity to add key Republican issues, such as attacking the Volcker Rule. Mr Crapo apparently deliberately avoided this in his Senate proposal to get Democrats on board.
The rule, part of Dodd-Frank, forbids banks from using customer deposits for their own speculative trading or for investments in risky funds. So far the Treasury is urging simplification of the rule rather than its repeal. Joo-Yung Lee, a senior analyst at Fitch Ratings, says: “There has been some acknowledgement by regulators of the complexity of Volcker.”
Meanwhile, independent economists emphasise there are uncertainties over the benefits to the economy of the US government’s tax cuts and bank deregulation.
For example, it is not clear that any relaxation of Dodd-Frank rules will boost growth or that banks will deploy the additional capital resulting from a freer environment in more lending, or in ways that increase investment, spending and hiring.
Fuelling the doubts, loans grew at a yearly rate of 4.1% in 2017, down from 7.3% in 2016, according to the Federal Reserve, with the growth in commercial or business loans, an important source of banks’ earnings, noticeably weak. One key reason for the decline, according to economists, is above average business lending in the past few years and high corporate debt. This dampens demand and also makes banks wary of lending more to companies.
Meanwhile, after successfully passing Federal Reserve stress tests in June 2017 and posting record profits in 2016, the biggest US banks, including JPMorgan Chase, Bank of America and Citigroup, as well as many regional banks, announced big share repurchasing plans and dividend payments to shareholders over the year to June 2018, amounting to more than 85% of their projected earnings, commentators and analysts say.
How much of an economic stimulus the Trump tax cuts will turn out to be, especially in the long term, is also a matter of debate. They are occurring after years of economic expansion, when unemployment is low, and the Federal Reserve, having raised short-term interest rates three times in 2017, has strongly indicated it will do so three more times in 2018, which could mitigate the law’s impact. Rising US interest rates mean higher earnings for banks on loans. However, long-term US interest rates have remained stubbornly low, and the difference, or spread, between 10 and two-year US Treasury bonds, a rough equivalent of banks’ profitability, was only about 0.5% at the end of December 2017, near its lowest level in a decade.
Indeed, Janet Yellen, at her last Federal Reserve press conference in December, said the tax cuts would make a bad US debt situation worse.
