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By Jeremy Glaser | 05-19-2010 09:59 AM

How Financial Reform Impacts Bank Investors

Morningstar DividendInvestor editor Josh Peters thinks the financial reform bill will force firms to return to traditional banking--but some will still thrive.

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. How will the financial reform legislation, working its way through Congress impact bank dividends? I'm here with Josh Peters, Editor of Morningstar DividendInvestor, to see how investors in banks will fare. Josh, thanks for joining me.

Josh Peters: Happy to be here.

Glaser: How do you think the financial reform legislation, in front of the Senate right now, is going to impact those stocks?

Peters: Well, I'll tell you, it depends very much on the firm. I think the financial services industry in this country, and globally, has certainly earned greater regulatory oversight. It has maybe in fact earned some public dressing down. I mean, what could be more embarrassing than being dressed down on TV by congressmen? You know, that really has to be humiliating, but look at what some of their actions had brought us to.

I think the way the industry is heading is actually in a relatively positive direction. For investors who bought a stock like a Wells Fargo for a big dividend saw that dividend almost entirely taken away, now just running at five cents a share per quarter. The industry is going to kind of migrate in the direction of the way a Wells Fargo has been running its business. It's going to be about taking deposits. It's going to be about making loans. It's going to be about getting repaid in full and on time, from the loans that they make, and being responsible to their shareholders, their employees, their customers, in a more comprehensive and traditional way in banking.

Now, what I like about Wells Fargo is it shows that you can have a very profitable bank without having to do what Goldman Sachs does, or what JP Morgan Chase does, all the derivatives activities. Proprietary trading, hedge funds, private equity, all the rest of that stuff, you don't need it in order to have a profitable bank that generates a lot of excess capital. And if Wells Fargo continues creating excess capital at the rate it has been lately, I think a dividend increase, even as early as late here in 2010, is a very strong possibility.

Glaser: But some of these traditional banks are still going to be impacted by this legislation. There's a lot of talk of regulating debit card fees, and overdraft fees, some of which have already come into effect, and some of which could, if this gets passed. Do you think these businesses will be able to overcome those obstacles?

Peters: I don't think that there's any financial services company that is going to be excluded, or completely untouched, from this legislation. The rules are tightening from all directions, and for everyone. But the rules are going to change much more dramatically from the hybrid universal banks, or investment banking operations like a Goldman Sachs, that really had their business models built off of deregulation. It's going to be much, much more difficult to adapt to a more regulated environment.

For somebody like a Wells Fargo, some of the bigger changes in this bill, about perhaps about having some real state regulation of their operation, state by state regulation of their operation, it's almost more of an IT problem and an employee compliance problem, as opposed to something that is going to radically change their business model.

But the way I look at it is that the bottom line is actually fairly simple. I mean, you can restrict the activities of traditional bankers, but to the extent that you restrict their activities, you are also perhaps also restricting access to credit. And that will lead to higher prices for credit. Customers will pay more on loans. They'll earn less on deposits.

Banks are going to have to make up for these additional operating costs somewhere. And I think those costs will be passed along to customers. The cost of capital in the banking sector, if anything, has gone up. And I would expect the better banks, that face less competition - now after all of the banks that were washed out of the system during the crisis - they're going to be able to capitalize on that.

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