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The Deal: Too Big to Merge?

Stocks in this article: WFCJPMBACCGSMS

The proposed supplementary leverage ratio requirement goes beyond those approved by the Basel Committee on Banking Supervision in 2010 and has drawn criticism because it provides no incentive for U.S. banks to hold less risky assets. The Basel rules require a leverage ratio with a 3% minimum of equity to assets, allowing banks to decide whether certain loans or securities are risky and require more equity to cover a potential default.

By contrast, the U.S. supplementary leverage ratio has higher absolute capital requirements and weighs a government bond for capital purposes in the same manner as a risky commercial loan. It also counts off-balance sheet exposures such as the grossing-up of derivatives toward a bank's capital requirements. Despite this -- and cries of foul play from U.S.-based SIFIs -- ratings agencies such as Fitch have characterized the leverage ratio as "tough but manageable" by the proposed 2018 effective date.

Some observers believe that additional capital levies might prompt some U.S. SIFIs to push into riskier areas as they seek higher returns. Killian argues that banks may also focus on business areas that do not require much capital support such as operations and payment processing.

Skeptics note that reorienting a business model toward processing may be challenging given it is a capital-intensive, commoditized business that has already consolidated. Among those that dominate the financial processing business are Bank of New York Mellon (BK), JPMorgan Chase and State Street.

More broadly, Spencer notes that new regulatory and capital requirements have already slashed returns on equity for large banks -- risking their appeal to investors if returns fall much further.

"For global SIFIs, returns on equity are about half what they were pre-crisis: ROEs were about 12% to 13% between 2004-2006 and today they are 8% or 9 %, so there's tremendous downward pressure on returns caused by the new rules," he says, adding that banks need both stronger loan growth and rate increases for sustainable earnings improvement. "Large banks' book-to-value ratios were at 2.5 to 3 times pre-crisis and are currently 1.5 times, so investors have concern about industry growth prospects."

Advocates of higher capital requirements argue that while ROEs are falling, the longer-term pay-off is far greater: a capital cushion to absorb losses and reduce the fragility of the banking system, slashing the risk of taxpayer bailouts in times of crisis. The intense focus on ROE is relatively recent. Banks in the 1950s and '60s were heavily regulated and had low ROEs while still providing ample lending for a booming, if very different, economy. Fierce competition in finance, public ownership and the ascendancy of shareholders put increasing focus on ROE in the 1970s and '80s, driving bank mergers, both geographically and by product line, and boosting leverage.

These advocates insist that a more sustainable banking system need not significantly stymie lending so long as lower ROEs are accepted as a reality of prudent banking. Critically, they argue, a banking system that aims for high ROEs is also one that incentivizes banks to move up the risk curve -- lifting the threat of potential losses. In any event, the rise of the financial markets have lessened banks' central role as a capital supplier, certainly in the U.S. and U.K.

Regulators are also turning increasing attention to the so-called shadow banking system of hedge funds, non-banks and money market funds. The Basel-based Financial Stability Board -- a regulatory task force for the world's top 20 economies -- published the first set of standards for the $60 trillion shadow-banking sector in August.

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