Driving gains through less regulation
In the wake of the 2007–2008 global financial crisis, US legislators passed many new rules for financial institutions. A decade later, we may be headed in the opposite direction, with regulatory rollbacks that could have a positive impact on the sector—and on big banks, in particular. Investors have largely overlooked this potential shift due to skepticism over President Trump's ability to advance his pro-growth agenda. But it may be time to take another look.
The most comprehensive recent legislation to govern the sector was the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act for bank oversight. It imposed an annual stress test to determine if banks have adequate capital to withstand severe financial or economic stress, and restricted banks from trading for their own accounts.
While helping to stabilize the financial system, Dodd–Frank has also significantly increased the costs of compliance and regulatory reporting and has pushed banks to hold much higher levels of capital (see chart). The capital build, in turn, has hurt returns on equity—a big driver of valuations. In addition, the legislation has caused investment banks to shy away from risk, inhibiting trading activity and market liquidity.
Avenues for relief
Moving forward, newly appointed pro-growth, pro-business regulators seem likely to take a lighter touch in interpreting these rules, essentially loosening the constraints on banks. Consider the stress test: The law only mandates that the test takes place annually; it doesn't spell out the particulars. To date, the stress test has included quantitative and qualitative components, and the opaque nature of the qualitative portion has caused banks to err toward conservative capital-allocation policies. New regulators could make the qualitative test more transparent or less stringent, or even drop it entirely. Any of these scenarios would give the banks more latitude to put their capital to the best possible use, potentially leading to better returns for investors.
The potential upside
Although no one knows exactly how the regulatory landscape will unfold in 2018, rollbacks seem likely. Estimates are that big banks with more than $50 billion in assets—which have seen a disproportionate share of the incremental regulations—could be among the biggest beneficiaries, with an estimated 5% to 15% boost in earnings. Regional banks, which have tried not to exceed the onerous $50 billion threshold, could become more interested in mergers and acquisitions (M&A), and investment banks could benefit from increased trading activity. Within the sector, stocks with valuations that are not factoring in the potential benefits of regulatory relief could provide some of the strongest opportunities for future appreciation.
Next steps to consider
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