Speculative and risky investments that caused the financial crisis of 2008 brought on sweeping regulatory changes across the banking industry. Now it may be the regulations themselves that help cause the next financial crisis.
Yes, new and improved safeguards have all been put in place for banks around the world since 2008. Just as ocean liners were required to put more lifeboats on their ships after the Titanic sank in 1912, big banks have been tasked with building up their capital buffers (i.e., cash reserves) to absorb any future financial losses caused by bad loans or heavy derivative losses and the like.
Banks traded on financial markets even have to meet a 4.5% common equity ratio and a “Tier 1” capital requirement of 6% by January 1, 2019, under rules set by the Basel Committee on Banking Supervision — meaning banks need to build a capital buffer twice as large as was required in 2008 to hopefully prevent another disaster.
But here’s the problem. Where the financial crisis of 2008 was caused by banks chasing too much profit, the next financial crisis may stem from banks earning nonexistent profit (or losses) over the next few years in an industry chock full of low interest rates, heavy and ongoing postcrisis lawsuits, and rising bad-loan debt.
In short, bad financial performance could keep banks from raising the capital they need to prevent another crisis. As WSJ‘s veteran financial reporter Paul Davies put it this week after some of Europe’s largest banks posted disappointing results for 2015:
“In truth, banks don’t face an acute crisis as in 2008. It is something that in some ways looks worse: a chronic profitability crisis that makes it impossible for banks to build up barely-adequate capital bases.”
Take one of Europe’s largest banks, Deutsche Bank, as an example. The $2 trillion bank posted a ground-shaking $7.5 billion loss for 2015 caused by €11 billion worth of litigation settlements and bad-loan write-offs.
FORTUNE analyst Stephen Gandel points out that Deutsche Bank will have to earn $24 billion in profits (after dividends and buybacks) over the next three years to meet the 5% leverage ratio requirement (another capital requirement score). Those kind of targets don’t bode well for Deutsche Bank, as CEO John Cryan recently warned, “I do not think that 2016 and 2017 will be strong years” after talking about the bank’s 2015 results.
Similar profit-stifling conditions persist for US banks too. As I wrote last year, large US banks have been plagued by the near-zero interest-rate environment, heavy lawsuits stemming from the financial crisis, and shrinking mortgage businesses as fewer consumers are refinancing. The two megabanks that reported any revenue growth in 2014 were Wells Fargo and U.S. Bancorp, which grew by a scant 0.34% and 1.58%, respectively.
And even with 2015 results being slightly more positive, the Fed signaling more caution about continuing its interest rate hikes — which would fuel interest margins and help US banks grow — have made investors drop US bank stocks faster than any other kind of stock this year.
In fact, the KBW banking index — which tracks the 24 largest US banks — is down 26% since its high set last July, signaling investors are just plain cynical about growth prospects for the industry. That’s exactly why some of the largest US banks are scrambling to slash costs in ways they never have.
As FORTUNE‘s Gandel explains:
“The large U.S. banks are required to have a leverage ratio of 6.75% by 2019. Most have that. But a year of losses would set them back just as the deadline is nearing. Investors have long assumed banks won’t have a problem meeting their capital requirements. Now, they are clearly starting to sweat.”
The world’s largest banks may collectively need to build as much as $1.2 trillion in capital between now and 2019 to meet regulations, according to Bloomberg analysts. Interest rate hikes may not be coming, the lawsuits continue to pile on, and capital requirements remain in place.
The clock is ticking for banks to be profitable again. Will they be ready?
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Christian Hudspeth is a company analyst for Dun & Bradstreet, researching and reporting on more than 1,000 banks and financial firms for Hoover’s database subscribers. Before joining Dun & Bradstreet, Christian was a managing editor, senior financial writer and analyst for a financial publishing company. His financial articles have been featured on MSN Money, Business Insider, Nasdaq.com, and several other well-known online publications. Before he was an editor, Christian worked in the commercial banking industry for seven years.