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Driven by more regulation and lingering pain from the financial meltdown of 2008 and 2009, banks have made great strides in becoming leaner and meaner. With the phasing in of Basel 3, starting January 1 of 2013, even more adjustments will be made to improve their existing financial positions.

This past September I wrote an article titled, "In banking, size really does matter." I wrote this article about how deregulation of the banking industry had created some monster-size banks and went on to say how, in some respects at least, the government had overdone deregulation. I mentioned the need for the government to reverse some of the massive deregulation of the 90's and early 2000's, and I listed some techniques available to the Federal Reserve for such an effort. One such method used by the Federal Reserve and the international central banks has been the implementation of the so-called Basel Accords - Basel 1, Basel 2, and Basel 3.

The Accords came from a committee composed of Central Bankers from all the G20 nations, plus a couple of other countries. They met in Basel, Switzerland, and therefore the name Basel was given to their proposals, which were agreed to by the participating central banks, including the Federal Reserve in the United States.

The first of the Basel Accords was implemented in 1992. It basically set minimum capital requirements for banks. With all the changes brought about by deregulation, Basel became obsolete very quickly. Its successor, the Basel 2 accord, went into effect in 2004. Basel 2 attempted to regulate risk management and capital requirements for banking throughout the world.

The Basel 3 Accord will take effect on January 1, 2013. It will gradually be phased through 2018. Basel 3 is our primary focus in this article.

There are basically 3 components of Basel 3. First, the reserve on risk capital requirements goes from 2.5% to 7%. For example, let's say the total capital of a bank was 200 billion, and 100 billion of that amount was deemed risk capital. The bank would have to reserve 7 billion. Under Basel 2 that reserve would have been 2.5 billion. The impact, then, of Basel 3 should be to lower the bank's return on capital and also to lower its risk exposure.

The second component of Basel 3 is to limit the size of bank balance sheets. In effect, this amounts to putting a cap on bank growth. Note that this component also puts restraints on a bank's return on equity.

Basel 3's third and final component is the 30-day liquidity stress test. At first glance, it seems almost brutal. First of all, the stress test assumes a global recession and a 5% fall in GDP. Secondly, it assumes an unemployment rate of 12% and a 50% fall in equity prices. Ouch! Believe it or not, though, such a dismal scenario is about what the banks faced four years ago. Please keep in mind that Basel 3 is emphatically not a forecast. It is a stress test designed to protect banks from the near complete meltdown we saw in 2008. And how a bank performs on the stress test helps determine whether or not a it can implement a share buyback program or pay out a dividend.

At the expense of falling ROE, our 20 largest banks in the United States are looking pretty good. Most are expected to meet all of the Basel 3 requirements way ahead of schedule. One of my favorite banks is Bank of America (NYSE:BAC). According to the CFO, Bank of America's Q3 reserve on capital was 11.41% - well ahead of the 7% required by Basel 3. Keep in mind, however, that Bank of America still faces some serious mortgage issues with Countrywide that are not fully resolved. Nonetheless, the bank has done a tremendous turn around on the balance sheet. I expect going forward we will see a significant improvement on earnings growth on a year-over-year comparison. Granted, the Fiscal Cliff could alter the earning situation in all financial institutions, but I am pretty optimistic.

With Basel 3 in place, banks will look considerably different than they did just a few years ago. With these new rules, layered on top of the Dodd Frank constraints, the deregulation of the 90's should be tightened up significantly. A combination of the new capital requirements, along with the elimination of proprietary trading and hedge fund businesses, banks are getting back to more traditional banking models. This development, of course, has and is driving return on equity closer to pre-deregulation levels. The negative effect from all this, though, will likely be P/E contractions throughout the industry.

This transformation of banks has also resulted in their balance sheets carrying less risky assets. Banks are now nearly flooded with US Treasuries. And this turn of events may imply an entire new set of risks that so far has not been tested and probably should be. The risk of inflation and (rising interest rates) could certainly have a negative impact on balance sheets. In an attempt to improve transparency in the bank financials, tighter rules have been implemented regarding mark to the market. Banks are required to price their assets to current market valuations. We know that when interest rates rise, prices of bonds fall. This could have a significant impact on valuations, and thus on balance sheets. I should mention that, under pressure from Congress during the 2008 financial crisis, FASB or the Financial Accounting Standards Board relaxed a number of the mark to market regulations. Who's to say that would not happen again? It used to be that banks could price your bond portfolio at face value if you were holding to maturity.

Keep in mind that, outside of stagflation, the norm has been for our economy to grow at a much higher rate than today to justify a rising interest rate environment. This could mitigate some of the potential for interest rate risk in the bank's portfolio in the near term.

One of my old mentors often advised buying companies with monopolistic characteristics. Well, folks, the banking industry increasingly fits that description. Banking affects our lives every day, whether we even think about it or not. It drives all aspects of our economy, and it's not going away. Banking has transformed itself due to regulatory changes driven by a near meltdown of our financial system, and the result is that banks today are becoming lean and mean. Outside of some uncertainties in the mortgage area, I clearly see a much stronger and vibrant industry on the horizon, especially for Bank of America and similarly-situated institutions.

My long term investment outlook for this group is quite healthy. My long-term favorites are Bank America, JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC). I expect share buybacks and increased dividends to be the norm in 2013, and these three companies should perform well in that environment. In fact for less inclined to invest in individual stocks the XLF (Financial Select Sector SPDR Fund) makes a lot of sense. Keep in mind these are long term recommendations, not simply a trade.

Source: Basel 3 Means Stronger Banks