Stricter Regulations Threaten Future Bank Profitability

The Financial Times reported this morning that international regulators are contemplating increasing capital requirements for banks on their complex debt instruments in order to discourage the “warehousing” of repackaged assets. According to current regulations in Basel rules, banks must hold significantly higher reserves against the risk of credit default in their loan book than their trading account. By requiring less capital against their trading accounts, banks can employ significantly higher leverage, thus increasing their returns. Increased leverage and returns were great when the debt binge was still a raucously fun party. According to the Financial Times, the significantly increased risk was ignored for a time because risk managers and regulators “assumed that VAR models were reliable.” In my my opinion VAR was very reliable, it had just been misinterpreted. What VAR was really trying to say was this:

We are confident that 99% of the time we will not lose more than [insert dollar amount]
We are confident that the other 1% of the time, we will lose an incredibly large and unpredictable amount of money.
We are extremely confident that if and WHEN we lose all of that money, none of us will care too much as we have all been paid handsomely for several years and will probably retire or start our own hedge fund.

In a different story last week, the Financial Times reported that the Fed is working on tightening regulations on broker dealers if access to the discount window should become permanent. The Fed, exerting its authority over investment banks for the first time, will more than likely require that broker dealers decrease their leverage ratios to be more in line with commercial banks. According to the story, this does not sit will with Goldman Sachs, who believes it has done a fine job of managing its leverage ratio of roughly 26 to 1. Lehman Brothers, on the other hand, has apparently offered to be extremely compliant and has promised to abide by any new regulations the Fed throws at them. Please don’t take the discount window away. Please.

Needless to say, new regulations reducing leverage ratios for brokers and banks are not bullish for future profitability. But investors keep sucking up new issuance after new issuance as banks continue to recapitalize as if this is the best blue light special they’ve ever seen at K-Mart. Naturally, everything will be back to normal once all of these pesky write-downs are behind us.