Market Overview

Banks Under Cloud in 2013

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The decision late last month to delay the introduction of new capital requirements for large banks may keep bank share prices under a cloud of uncertainty for 2013. The new rules would require banks to raise new equity capital, shrink their balance sheets or some combination of the two.

The new rules, known as Basel III, were formulated with the idea of making large banks safer following the collapse of Lehman Brothers in 2008. Basel III requires large, too-big-to fail banks all over the world to hold enough capital to find themselves for 30 days in the event of another financial crisis.

When Lehman Brothers failed in September 2008, banks stopped lending to each other in the interbank market. Because Lehman had issued a lot of debt, which was widely held by banks, no one could determine how risky a loan to any particular institution might be. Liquidity and credit dried up immediately with devastating consequences that we are still living with today.

The new rules were supposed to go into effect on January 1, 2013. However, in late November, U.S. banking authorities unilaterally decided to delay indefinitely the implementation of the new rules. According to Reuters, “The 19 largest U.S. banks subject to the Fed's stress testing program represented over 90 percent of the assets of internationally active U.S. banks, and three-quarters of the assets of all U.S. banks…”

Reuters continued, “The rules, which triple the amount of basic capital banks need to hold, are meant to be phased in over a six-year period starting in January 2013.”

Although the U.S. says it is still committed to implementing Basel III, there are disagreements over how to implement the rules and how to unify the rules among every country's banking system.

Following the U.S. decision to postpone Basel III, European banks petitioned the EU Internal Market Commissioner to allow European banks to delay the implementation of Basel III as well. "We are now very troubled over the possible repercussions that the most recent statement from the US Authorities may have for the international competitiveness of Europe's banks," the European Banking Federation wrote, asking the EU to delay the new rules until January 1, 2014.

Reuters wrote, “It said EU banks were facing sweeping regulatory changes including new capital requirements and liquidity buffers, and the creation of a EU supervisory authority. ‘All the while, our U.S. competitors will not have matching obligations imposed on them in parallel, or in a foreseeable future.'"

The European Banking Federation today asked the EU for a “…review of tougher financial regulations on the eve of their adoption as the region sinks into a recession, dimming prospects of raising $621 billion in capital needed to meet the rules,” Bloomberg reported.

While, on the surface, a delay in implementing the new rules seems positive for the banks, it does introduce a new level of uncertainty for 2013. For example, the delay in implementing the new rules may not necessarily delay the deadline for meeting the new capital requirements. The might mean that banks will have only five years to adjust their balance sheets instead of six years.

Bank may also remain reluctant to lend to each other for as long as there is uncertainty over how much capital they will need to support their assets in 2013 and beyond. While this is particularly true of European banks, this uncertainty could well spill over into the U.S. market. The sooner there is clarity over how much capital the banks needs, the better.

Investors should be concerned over the timing of introducing the new capital requirements. If banks will be forced to raise significant amounts of new equity during a recession or during a market downturn, it could prove to be a costly exercise.

On the other hand, if regulators continue to postpone the implementation of the new capital requirements, it calls into question their commitment to the rules and to the idea of international coordination of bank capital.

Generally speaking, uncertainty is bad for share prices and banks are no exception. Investors may want to consider a short position in the SPDR S&P Bank ETF (NYSE: KBE), particularly if KBE breaks below major support around the $22.50 to $22.75 area. If banks turn weaker, buying the Pro Shares Ultra Short Financials (NYSE: SKF) might also make sense

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