Why bank shares could head downhill in financial year 2017

The Australian Financial Review is reporting that international equities manager Platinum Asset Management Limited (ASX: PTM) remains bullish on European banks despite suffering big losses on the bank positions it has held so far in 2016. In fact The AFR is reporting that Platinum’s holding in European bank stocks “accounted for more than almost half of the fund manager’s losses so far this year”.

Yet, Platinum has been adding to its bank positions in the belief they are undervalued and that risks around Britain’s recent vote to leave the European Union have been overblown. The passage of time may (or may not) show that the price corrections in some European, Australian and global banks as a result of Brexit were overblown.

Although there is another big reason bank share prices have been falling globally over the past year and it’s nothing to do with Brexit.

Regulatory Pressure on the Banks

The large elephant in the room for anyone choosing to invest in big bank shares at the moment is the toughening regulatory environment via the Basel III capital adequacy requirements and anticipated further reforms known as Basel IV potentially in 2017.

Although it may seem a while ago now, the Great Financial Crisis of 2009 is now widely regarded by politicians, economists, central bank policymakers and bank regulators as being largely caused by the excess deregulation of the banks prior to the GFC.

In 2008 some banks were reportedly so leveraged that they borrowed $50 for every $1 dollar in shareholder equity on their balance sheets. When credit markets seized up due in part to sub-prime lending the banking system and world economy teetered on the verge of collapse largely as a result of the out-of-control leverage across the banking system.

It has taken global governments a predictable amount of time to respond to this now commonly accepted wisdom, although the legislative response continues to be cranked up.

Legislative reform has been enacted via the Dodd Franks Act in the US and Banking Reform Acts in the UK for example, while the Basel Banking Supervisory Committee is also now beginning to roll up its sleeves, probably under renewed inter-governmental political pressure.

The Result?

The Basel Committee is where central bank policymakers meet national banking regulators and it remains in a toughening regulatory cycle that is increasing the capital adequacy requirements on the banks. Banks must hold capital in reserve on their balance sheets as a proportion of risk weighted assets to make sure they are not too leveraged in the event of another global credit crunch or similar scenario.

The Basel III reforms have resulted in a round of share price lowering capital raisings for many global banks and the widely anticipated Basel IV reforms will also impose tougher capital reserve requirements on banks globally.

In fact there’s not a snowball in hell’s chance that the banks are going to get an easier regulatory ride over the next few years as banking regulators and the Basel Banking Supervisory Committee go all out to avoid past mistakes.

Tougher capital requirements mean more capital raisings may come in 2017.

Before you consider investing in banks because the share prices look cheap you should consider how your shareholding may be diluted if the banks are forced into capital raisings in 2017.

In Australia banks like the Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd. (ASX: NAB), Australia and New Zealand Banking Group (ASX: ANZ) and Westpac Banking Corp (ASX: ANZ) have already been forced to raise capital once and another round of capital raisings is likely to put more downward pressure on share prices. Rather than raise capital via the issue of equity the banks could slash dividends to save cash, but that is likely to put even greater downward pressure on their share prices than any dilutive capital raisings.

Foolish takeaway

While the Australian banks have some attractive trailing and forecast dividend yields it would pay for investors to factor in the toughening regulatory environment they are now facing when considering the investment case.

Falling bank share prices over the last few years around the world are no coincidence and don’t be surprised if the regulatory squeeze continues to impact their returns.

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Motley Fool contributor Tom Richardson has no position in any stocks mentioned.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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