Gauging The Impact of Dodd-Frank on the ‘Too Big to Fail’
Citigroup (NYSE:C), Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM) and Goldman Sachs (NYSE:GS) were some of the large financial firms that received bailout funds under the Troubled Relief Assets Program (TARP) program the US Treasury put together at the height of the financial crisis of 2008. [1] In an attempt to reduce the need for such interventions in the future and to formalize the process of handling such cases of large scale financial bankruptcies, the Dodd-Frank Act was signed into law about a year ago. [2] The Act has placed limitations on some activities of large banking institutions, which could impact their valuation due to higher capital adequacy requirements that could influence the banks’ borrowing costs, trading operations and dividend policies.
Reduced Federal Intervention Could Raise Borrowing Costs
While critics have questioned the efficacy of the Dodd-Frank Act in resolving the ‘too big to fail’ dilemma, speculation that federal authorities may have a limited role to play in any future intervention has driven Moody’s to place its debt ratings for Citigroup, Bank of America and Wells Fargo under review. Moody’s says that the assumption of federal backing lifted the ratings of these banks by 3-4 notches and that reduced support may lead to a lower rating. [3]
Increased borrowing costs may put pressure on the margins that banks earn on their trading operations as well as commercial and retail loaning businesses. Let us look at the impact of lower margins on the consumer banking and the credit card business of Citibank.
We currently forecast Citigroup will maintain a 3.8% net interest margin on its consumer banking business. A drop of 0.5-0.6% in the margins of this division can lead to a 5-10% downside to our $56 price estimate for Citigroup stock.
Limitations on Trading Activity and Stricter Capital Regulations
The Dodd-Frank Act places emphasis on reducing the possibility of future bankruptcies and seeks to limit the exposure of large banks to risky trading activities. These provisions have become popular as the Volker Rule and many banks have already taken steps to reduce their exposure to proprietary trading to comply with these directives. You can read more on this topic in our article Citi Shuts Another Prop Group as Banks Prepare for Volcker Rule.
As these banks look to regain investors’ confidence, limiting the capital allocated to trading due to higher capital requirements could be just one area that impacts these banks’ valuations. According to our estimates, 35% of Citi’s value comes from sales and trading compared to 55% of for Goldman Sachs and 16% of JPMorgan.
Living Wills & Dividends
‘Systemically important’ banks will also be forced to submit ‘living wills’ to regulators that can guide future dilution in case the bank goes bankrupt. Failure to comply with this directive can lead to a penalty in the form of increased capital requirements. [4] These directives could have serious repercussions on Citigroup and Bank of America as they are already under pressure to increase their capital holdings, forcing them to limit dividend payouts. [5]
As many of the US banks have announced plans or at least the intentions to increase dividends in the coming years, this will be another area to watch in relation to government scrutiny given revised capital adequacy requirements.
Click here for our full analysis of Citigroup | Click here for our full analysis of Bank of America | Click here for our full analysis of JPMorgan
Notes:- Bailout Recipients, ProPublica [↩]
- FDIC Says Dodd-Frank Act Ends “Too Big To Fail” Era, Problem Bank List [↩]
- Moody’s reviews BofA, Citi, Wells Fargo supported ratings for downgrade, Moody’s [↩]
- Too Big to Fail Ends With Wave of a Magic Wand: Jonathan Weil, Bloomberg [↩]
- Having No Dividend Is Hurting Bank of America, EDividendStocks [↩]