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Must-know: Why regulations could affect bank profitability

Russ Koesterich, CFA of BlackRock

Why the banking sector is better, but with room for improvement (Part 4 of 5)

(Continued from Part 3)

2.) The regulations designed to make banks less risky may impair the global banking sector’s profitability going forward. In the wake of the 2008 financial meltdown, new regulations across the globe have significantly increased the amount of capital that banks must hold, reduced fee income streams and led to much higher regulatory compliance costs. And the tight regulations are likely here to stay given that politicians will probably err on the side of restriction going forward to help prevent a repeat of the 2008 crisis.

Market Realist – New regulations have been introduced under the Basel III Capital Adequacy framework. These regulations have increased the capital adequacy ratio by 2%. A new ratio for controlling excess leverage has also been introduced. This measure expects banks to maintain a leverage ratio of at least 3% at all times. This effectively means that for every $1 of capital held by the bank in reserve, it can lend $33.

More stringent laws have been introduced by the Federal Reserve and Federal Deposit Insurance Corporation in the U.S. These laws state that the eight biggest systemically important U.S. banks (XLF) have to maintain a leverage ratio of 5%. A leverage ratio of 5% would mean that for every $1 of capital that a bank holds in reserve, the bank can lend only $20.

Market Realist – The graph above shows the capital shortfall likely to be experienced by banks like Goldman Sachs (GS), JP Morgan Chase (JPM), Citigroup (C), and Bank of New York Mellon (BK) due to the introduction of a capital lever. The figures are as of July 2013.

Read on to find out what this means for investors.

Continue to Part 5

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