A few weeks ago, I had the pleasure of presenting at AFP’s annual conference in Boston. The topic was how FinReg (Basel III and Dodd-Frank) is impacting banks – and how those effects are trickling down to corporate customers. The thesis is pretty straightforward: In an effort to head off future bank failures, FinReg will require banks to hold increased levels of higher quality capital, while also bolstering their liquidity. As we all know, equity capital is expensive and banks are loath to issue more capital if they don’t absolutely have to, since new equity issuances dilute current shareholders.
Banks have a number of different ways that they can meet the new capital thresholds. They can grow into it via profits since net income (less dividends) adds to the retained earnings account. In the early stages of the recovery, when CEOs didn’t seem too concerned about FinReg, I think many believed that the economy would recover sufficiently quickly to allow them to grow equity organically. But with the economy remaining stagnant, and with the clock ticking,banks are having to find other avenues.
Since banks have to meet a target equity ratio – and not a specific equity dollar amount – the next natural step is to change the denominator (remember:capital ratios are capital divided by risk-weighted assets). If you can’t increase the numerator fast enough, another option is to decrease the denominator. Some banks have been doing this in recent months by exiting business lines and selling off stakes in minority investments.
Another step – an unfortunate one – that more banks are taking, is to increase net income by decreasing expenses. In banking,a major expense is personnel, so it is hardly surprising to see a number of banks announcing layoffs. Bloomberg ran a story this morning on the wave of layoffs hitting the sector this year. Traders and investment bankers seem to be especially hard hit.
Expect to see more of this over the next year or two. We have all become inured to stories of bank layoffs, but I think that these waves might be different. The moves the banks have made over the past few months, with asset sales,and now with layoffs, may signal the beginning of a changed banking model. With capital ratios rising, allocating capital – and earning a decent return on it – is front of mind for bankers. Riskier businesses, such as trading, will now require more capital than in the past. In a slow-growth economy, some banks are now realizing that it may not be worth it to be in those businesses.