Washington Targeting Wall Street Leverage

Includes: BAC, C, GS, JPM, MS, WFC

The leaked draft of a proposed bipartisan bill could have serious implications for the banking industry in the United States, as well as investors in the financial sector. According to a Bloomberg report, the bill would require all banks to maintain 10% equity capital and an additional 5% for institutions with greater than $400 billion in assets. This requirement is much more stringent than expected by the market and would radically change the banking landscape.

Since the Lehman Brothers bankruptcy nearly five years ago, there has been a great deal of rhetoric from Washington directed squarely at Wall Street. Despite the victories claimed by politicians for initiatives such as the Dodd-Frank Act and the Volker Rule, banks have largely retained free reign with regards to risk taking.

The London Whale incident at JPMorgan (NYSE:JPM) is evidence that the best run banks can still incur massive losses without effective risk management and oversight. Bank balance sheets are larger than ever, and with strength finally returning to the housing sector, aggressive lending practices are once again starting to grow.

Based on the new bill however, the "Too Big to Fail" banks may be facing another severe round of regulation which aims to limit such risk taking in the future.

The six largest bank holding companies: Bank of America Corporation (NYSE:BAC), Citigroup Inc. (NYSE:C), Goldman Sachs Group Inc. (NYSE:GS), JPMorgan Chase & Co., Morgan Stanley (MS) and Wells Fargo & Co. (NYSE:WFC) would all surpass the $400 billion asset threshold. These companies would have to reduce balance sheets below the threshold through asset sales, unit spin offs, or meet the higher requirement of 15% equity capital.

Total Asset Held by Banks

Source: YCharts.com

Such onerous capital requirements would considerably affect the nation's principal lenders ability to finance everything from home mortgages to small business loans. It is probable that this reduction in dollars in circulation would negatively impact economic growth in the short term.

In addition, the banks' profitability would certainly suffer with reduced leverage. The full scope of the bill is not known, and could potentially contain other requirements that would impact the way the big banks conduct business. The industry has been moving forward on the belief that Basel III would form the framework used to manage leverage ratios and risk management, but the disclosure of the senate bill clouds any suppositions.

Basel III Moving Slowly

The heel dragging shown by US banks in adopting Basel III standards, international rules that establish capital ratios, means that the United States is among the laggards in implementing the new global regulations. According to an analysis conducted by the Financial Times, and supported by an SNL Financial report, "(t)he banking industry's backlash toward the proposed Basel III rules caused regulators to delay their implementation late in 2012."

One of the more notable aspects of the draft bill by US Senators David Vitter and Sherrod Brown is that it would remove the United States from the Basel III Accord and unilaterally dictate risk parameters for domestic banks. Additional controls would reportedly be put in place to prevent banks from using holding companies and other vehicles to circumvent the new capital rules.

Exactly how these rules would be implemented or over what time frame is unclear. It is not even certain the bill will make it to the Senate floor, let alone bear any resemblance to the leaked copy. The only reason the draft is even public is due to a bank lobbyist exposing the document in order to enlist industry support, according to the spokesman for Senator Vitter.

Impact for Investors

It is premature for investors in the financial sector, or bank management themselves to be too concerned about the proposed legislation. The law-making process is slow with many moving parts, shifting allegiances, and numerous competing interests to be balanced. It's politics.

The "Too Big to Fail Banks" will deploy their legions of lobbyists in an attempt to curtail, or at the very least slow, any new laws perceived to hurt the bottom line. Nonetheless, the tide does slowly appear to be turning towards increased rules for how large financial institutions do business in order to reduce systematic threats to the overall economy.

If changes similar to those proposed in the most recent bill do begin to gain more support, any holdings in the financial sector will require a shift in analysis to reflect the new paradigm. While there would certainly be banks that are hurt in the short term, tremendous investing opportunities could also arise in a transformed banking landscape. Time will tell, but the draft bill currently causing anxiety from Washington to New York could just be round one of an escalated battle which it appeared Wall Street had already won.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.