Brave New World of Financial Legislation

There is still much to be written about and finalized in the specifics of the new United States financial legislation. Since over 200 new rules are expected, which may take up to five years to implement, we think the ultimate implications remain uncertain and may vary widely from one institution to another. However, we think the publication of the broader rules is a good opportunity to size things up a bit, at least on an elevated level. Here we provide some detail regarding the main points of the new legislation and an idea of the potential impact to some banks in our coverage universe. All figures are estimates and come from various sources, including earnings calls, company presentations, and management comments. The numbers presented may not be uniform across firms. Despite this, we think they clearly show that the regulations seem to affect larger banks much more dramatically than they do small banks.

We're particularly worried about how the legislation will impact companies like  Bank of America (BAC) who will be affected from multiple angles, like size (deposit insurance), trading activities (Volker rule), debit card issuance (interchange fees), and checking account income (overdraft fees). Other smaller players should also feel the impact given their reliance on a particular field, like  TCF Financial  (overdraft and interchange fees) and Fifth Third (FITB) (capital restrictions). In our view, small community banks like  Cullen/Frost Bankers (CFR) will not suffer nearly as much.

The new regulations will affect financial institutions in a variety of ways. In general we anticipate banks will yield lower returns from lower revenues, more elevated expenses, and higher capital requirements, but we expect the financial system as a whole will become more stable. Provisions cover consumer protection, systemic risk, trading, derivatives, capital and liquidity, regulator structure, and shutdown of troubled firms. Among these, we selected five rules that have garnered widespread attention. Although it does not detail each regulation individually, the Senate Committee on Banking, Housing and Urban Affairs published a high-level view on the financial reform that can be found here.

Interchange Fees (Durbin Amendment)
This rule limits the fees paid for debit card transactions by merchants to issuers, which are set by card networks like  Visa (V) and  MasterCard (MA). The rule will limit the fee to a certain rate, which the Fed has to establish by May 2011. Hence, the financial impact and its timing are uncertain. Nonetheless, this will mean lower fee revenue for the largest issuers. Although the rule applies directly only to banks with over $10 billion in assets, we think smaller banks will also be impacted indirectly as card companies lower the rates across the board in order to avoid a discriminatory pricing structure. Fifth Third, for example, estimates a $15 million annual revenue decline (about 0.2% of net revenues) for each 10-basis-point reduction. In addition, we think TCF Financial,  SunTrust , and  Old National (ONB) also have a significant income stream at risk.

Trust Preferred Capital Exclusion (Collins Amendment)
This amendment excludes Trust Preferred securities, or TRUPs, from being counted as Tier 1 Capital, a measure used by regulators to assess a bank's solvency. We expect banks' capital needs to be additionally impacted by likely changes to the current capital ratio minima. We think this will force some banks to retire their TRUPs and/or exchange them for common equity, a typically more expensive form of capital. Even though the phase-out period will not begin until 2013, some firms may take action soon, especially those that have not issued much capital in the form of TRUPs. Of note,  Comerica (CMA) just announced it will retire $500 million of TRUPs in October. With this move, Comerica will eradicate all its TRUPs, but these are a mere 80 basis points of its Tier 1 capital. In contrast,  BB&T Corporation (BBT) and Fifth Third have nearly 300 basis points worth of Tier 1 capital in TRUPs. Next,  KeyCorp (KEY),  M&T Bank (MTB),  New York Community Bancorp (NYB), SunTrust, and  US Bancorp (USB), are in the 200 basis point vicinity, by our calculations.

Derivatives (Volker Rule)
The Volker Rule restricts proprietary trading activity in deposit-gathering banks and also limits their investments in hedge or private equity funds, based on the firm's capital position. We think the impact will be minimal in regional banks, since they do not typically engage in either practice. However, trading revenue at larger companies can become affected.  Goldman Sachs (GS) could be one of the hardest-hit, with roughly a $1.5 billion hit to revenues. Also,  J.P. Morgan Chase (JPM), Bank of America, and  Morgan Stanley (MS) could see a reduction in revenue of about $0.5 billion, $0.4 billion, and $0.2 billion, respectively.

Deposit Insurance
Instead of assessing fees based on deposits, as is currently done, the FDIC will charge deposit insurance fees based on a bank's assets less its tangible equity. Thus, better-capitalized banks that have a sturdier equity cushion will pay relatively less. In addition, the Deposit Insurance Fund's reserve target will be moved from 1.15% of insured deposits to 1.35%. We think most of the burden will be borne by the largest banks (those with assets over $50 billion) but expect all banks to see an increase in the insurance expense line. For example, both Comerica and US Bancorp could feel a haircut equivalent to about 1% of revenues through a rise in expenses of $30 million and $200 million, respectively.

Overdraft Fees (Regulation E)
This highly publicized regulation forbids punitive overdraft charges unless the customer explicitly "opts in" for such a service. Before, consumers could spend more money than they had in their checking accounts (by "overdrawing" them) but would incur hefty bank fees for doing so. So far, we have seen relatively high opt-in levels of over 50% at many of the institutions we cover, like TCF Financial and  First Horizon (FHN), as most firms are actively encouraging customers to opt in. Banks' overdraft fees will likely drop, as not all customers will opt in, and we anticipate banks will make up for the fall in revenue at least in part by raising the price for these transactions, imposing other fees on customers' accounts, or eliminating their free checking products. By our estimates,  PNC Financial (PNC), US Bancorp, and  Commerce Bancshares (CBSH) could all see net revenue decline by about 2% because of lower overdraft fees.

In sum, we think banks, especially the ones with over $50 billion in assets, will see their bottom lines negatively impacted by lower revenues and higher expenses. However, we anticipate these companies will find ways to make up for the lost income. As happened with the CARD act of 2009--which limited fees and arbitrary interest hikes for credit card holders--banks will somewhat mute the negative effects of the legislation by taking actions like imposing higher starting interest rates and annual fees or reducing benefits. That said, the rules regarding capital and liquidity will likely be much more difficult to surmount, given all the attention these two items are getting in the international arena with the new international banking standards. Nonetheless, we think that the long phase-in periods will allow most institutions to adapt and carry on with their business, albeit with lower profitability.