published Wednesday, May 30th, 2012

PersonalFinance: Bank safety rules will challenge profits

Travis Flenniken

Recent and upcoming changes in bank regulations should make banks stronger, but also will likely make it more difficult for them to create wealth for their shareholders.

The primary responsibility of a bank regulator is to ensure that banks can survive a downturn and repay their depositors, giving little consideration for bank stockholders.

Nationally and globally, new regulations are on the horizon that will improve the survivability of banking institutions, but these measures are likely to reduce returns to shareholders. Perhaps in this environment, it makes more sense to be a creditor than a bank stockholder.

The FDIC issued a report last week that stated bank profits had increased 23 percent from the previous year. However, rather than profit growth coming from new loans, it was because less cost was allocated to loan loss reserves. The report went on to explain that the industry is in good shape as banks continue to accumulate more capital and the number of bad loans decrease.

Last month, the Federal Reserve gave 19 banks a rigorous "stress test" to evaluate how they would perform in a financial crisis. Citigroup, SunTrust, Met Life and Ally Bank were the only institutions to fail, demonstrating a much stronger bank credit environment.

Global policymakers are pushing banks to increase their capital base.

Under new Basel III rules, 29 systematically important financial institutions (which include the largest U.S. banks) must increase their capital over the next several years.

Bank capital comes from two places -- out of bank profits and by selling new stock. Either one is generally bad for stockholders, as profits are plowed back into the bank rather than paid out as a dividend, or shareholders are diluted when new shares are issued.

The ratings agency Fitch issued a warning last week stating that Basel III probably will cause banks to hold onto future earnings, cut shareholder dividends, sell riskier assets, hold lower-yielding securities and issue new stock.

Fitch predicted that banks needed to raise $566 billion in capital in the coming years. The report estimates that stricter capital requirements could reduce the median return on equity to 9 percent from current return of about 11 percent.

The Dodd-Frank Wall Street Reform Act changes the landscape for banks in a number of areas.

One of the major changes in the act was the use of bank-issued trust preferred stocks (TruPS) and their inclusion as a form of bank capital. TruPS are preferred stocks issued by financial institutions which are senior to common stockholders and pay a higher dividend than common stocks.

These have been popular securities issued by banks because they were an easy way to increase capital without diluting common shareholders, plus they have favorable tax treatment. However, when banks come under stress, such as in 2008 and 2009, the use of TruPS can accelerate a bank's decline.

Dodd-Frank ends the benefits of TruPS for banks with more than $15 billion in assets. This new regulation will ultimately make banks safer and stronger, but also likely will reduce return on shareholder equity.

In light of these regulatory changes, preferred stocks issued by banks may be more appealing to investors than common stocks.

A preferred stockholder is essentially an unsecured lender or creditor to the bank. The primary form of return to the investor is the income the stock produces. Preferred stock has an expiration date and it is senior to common stockholders. The yields of bank preferred stocks vary by the perceived safety of each institution.

A word of caution: Some preferred stocks issued by banks are TruPS. Since the Dodd-Frank changes the rules related to TruPS, it allows the banks to call or retire the securities before their expiration dates. The implications are serious, as an early call can cause an immediate loss of principal if the security is purchased at a premium to the redemption price.

It's a good news/bad news story. The good news is that banks are arguably stronger than they've ever been, hopefully prepared to weather the next economic storm. A safer bank means a stronger credit, which makes preferred stocks more attractive.

The bad news, at least for shareholders, is that it will force banks to hold on to more capital, likely putting pressure on stock prices for years to come.

Travis Flenniken is a Chartered Financial Analyst for Campbell Asset Management.

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