Banks could earn a lot more money if the incoming administration follows through on its promise to cut regulatory red tape. Image source: iStock/Thinkstock.
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Over the past eight years, the bank industry has been laboring under one of the most stringent regulatory regimes since the Great Depression. This has not only driven up banks' regulatory and compliance costs, but it's also made it harder for them to generate revenue.
Donald Trump has promised to reverse this, saying on the campaign trail that his administration will "dismantle" the Dodd-Frank Act. If he follows through on that pledge, it could translate into a profit windfall for banks.
There are a number of ways that regulators, operating under the authority of the 2010 Dodd-Frank Act, have clamped down on bank profits, but one of the most significant insofar as Bank of America (NYSE: BAC) and other megabanks are concerned revolves around heightened liquidity rules.
One of the lessons regulators, bankers, industry analysts, and investors relearned in the financial crisis was that banks rarely fail because they don't have enough capital and are thus insolvent. A typical bank tends to fail instead from a lack of liquidity -- it finds itself unable to satisfy a rapid increase in withdrawal requests from depositors because too large a share of its assets are invested in loans, which can't be readily converted into cash.
As I've written in a companion piece about JPMorgan Chase, this was the case at Bear Stearns, the nation's fifth largest stand-alone investment bank at the time of the crisis, which came within a hair's breadth of failure in March 2008 until JPMorgan Chase stepped in to rescue it. As Patricia Chrisafulli wrote in a short biography of JPMorgan Chase CEO Jamie Dimon:
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Industry observers say they believe that Bear Stearns was adequately capitalized... The problem, however, was that Bear Stearns faced a run on the bank as funds were withdrawn and sources of short-term financing dried up.
In response to this, regulators tweaked existing capital rules and introduced new rules aimed specifically at boosting liquidity throughout the bank industry and at the nation's biggest banks in particular. Out of necessity, in turn, Bank of America has had to allocate an inordinately large share of its balance sheet to cash and low-yielding, highly liquid government securities.
Bank of America's balance sheet sports $522 billion worth of high-quality liquid assets. That equates to just under 24% of its total assets.
Data source: Bank of America'sthird-quarter earnings release. Chart by author.
There's no question that this buttresses Bank of America against future crises, but it also weighs heavily on the North Carolina-based bank's bottom line. As I've noted previously, the average annualized yield on its highly liquid assets is around 1.5% compared to the annualized yield on its loan portfolio of 3.72%.
This means that for every $100 billion worth of low-yielding liquid assets that Bank of America reallocates into higher-yielding loans, the bank would earn around $550 million a quarter in added interest income. That's a rough estimate, but you get the point.
There's no guarantee that the incoming Trump administration will in fact roll back the liquidity rules. However, given his stated desire to free up banks to loan more money, as well as his promise to dismantle Dodd-Frank, a central component of which are more stringent capital and liquidity rules, then it seems like a reasonable assumption that he and his allies in Congress may do just that.
If they do, it could translate into a profit windfall for Bank of America and its investors.
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