Banks to become less profitable

So, there they are, the new Basel rules for solvency. Effectively, the required capital base to run a bank will have to double over the next 8 years. Despite what industry representatives will tell you, it is good news for the rest of us. Let me explain.

In the past 20 years or so, the banks' importance in the economy has grown disproportionately, and the weight of the bank's stock in the stock market indices has followed.

Most of the explanation is that banks essentially have been very imaginative in influencing what could be counted as "capital base". As a result, the bank sector has been able to inflate their balances, and thereby increasing the return on the equity. As a consequence, banks have been highly profitable in the past.

The way banks operate has also had a tendency to allow them to increase loans when the economy was doing well. Conversely, they were quick to cut back lending activities once the economy was doing badly. By having this "procyclical" element, the banks have played a role in augmenting the volatility of the economy as a whole.

The crisis that began in the banking sector was to a large extent caused by the banks effectively increasing their leverage in the pursuit of a higher profitability. They did so by pushing the possibility of using their own investment products (mortgage loans, CDO) as part of their capital reserves. When that is a possibility, of course the banks could leverage their real capital harder and earn more money.

Obviously, when the sub-prime crisis started, many banks saw that a part of their reserves simply evaporatedand the banks became insolvent overnight. Since they did not have detailed knowledge of how bad the situation was at the neighbour's, they stopped lending to each other. The rest is history.

I wrote more than a year ago that one element in the Big Cleanout would be stricter capital rules. That is exactly what we are getting now. Unless the banking industry manages to lobby significant changes to be introduced between now and 2018 when the rules are fully implemented, it will mean that the profitability of the banking sector will trend downwards over the coming years. Probably it will also mean that the finance sector will end up weighing less in the stock market indices.

In my book, it is all good news. Of course we all need an effective solid banking sector. Increasing the capital reserve will only contribute to that. Tightening the rules for what can be counted as capital will also be positive. Reducing the banks' possibilities of using the capital reserves to play the financial markets will not be a negative influence on their lending activities.

Banking industry representatives have already been out there telling that the new rules will "delay the recovery". Excuse me! For new rules that are implemented in 2018?? In the past year, at a time of record profits and government guarantees, the banks have not resumed lending but have preferred to place their liquidity reserves with the central banks and play the bond market yield curve as best they could.

The risk willingness of the sector has shrunk dramatically in the recent past, and leads to yet another bout of behaviour that holds the rest of the economy hostage. This time it delays the recovery.

The banking sector as a whole had demonstrated its greed-driven incompetence beyond any reasonable doubt in the past two years. So when regulators now tighten up the rules, it is in order to protect the rest of us from a yet another repeat performance. That implies reducing that bank balances and increasing the capital reserve requirements. Time for the banking sector to go back to work.