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US, EU banks face rough year ahead

Stalling economies, crumbling assets, tough new capital rules and shrinking avenues to make money paint a rough year ahead for banks on both sides of the Atlantic.

That spells bad news for the economies that depend on banks to fuel investment by industry and consumers.

Banks in both regions are under the gun to raise hundreds of billions of dollars to strengthen their financial foundations, to meet the new Basel III standards on capital adequacy and liquidity, and to assuage ratings agencies threatening downgrades.

In Europe, economies are already teetering on the edge of a new recession and the eurozone crisis has spiked banks’ funding costs.

So generating enough capital from earnings to meet Basel capital ratios could be downright impossible, raising the spectre they will have to tighten lending – making it even harder for economies to grow, analysts say.

American banks are better able to generate new capital needed from earnings, but the burden is likely to deeply impact returns for investors, analysts say.

Although the US economy is growing, new regulations aimed at curbing the abuses that led to the 2007-2008 financial crisis, and new consumer protection rules, are cutting back business areas that were strong sources of pre-crisis banking profits.

That means US banks will find it tough to make a buck as well.

“All lines of business will see a sharp rise in capital requirements and a decrease in profitability,” the Boston Consulting Group said in a banking industry survey last week.

The entire industry is undergoing a sweeping change, said Ranu Dayal, one of the report’s authors.

“The banks have to think through the businesses they are in for the future.”

The industry is facing “a broad attack on revenue sources,” said Rodrigo Quintanilla, a banking analyst at Standard & Poor’s.

“The banks are trying to figure out how they are going to make money.”

Boston Consulting’s survey of 145 banks worldwide said EU banks need €221 billion in new capital to meet Basel III standards – three times the amount of new capital they have been able to raise since the financial crisis struck.

Banks elsewhere, mainly in the United States, need €133 billion to meet Basel III requirements, which are being phased in from next year through 2019.

Much of the demand is from the 29 largest banks designated as “globally systemically important banks” for which Basel has set higher capital ratios. Eight are US banks and 17 are in Europe.

While those rules are meant to protect the global financial system from the impact of a big bank collapse, the high ratios means a higher cost of capital relative to the banks’ business, squeezing profitability.

The pressure is greatest in Europe, where banks are straining to cope with rapidly deteriorating assets and huge writedowns in the value of eurozone sovereign and commercial debt holdings, especially that of Greece.

But the European Banking Authority has accelerated the pace for banks to strengthen their capital, saying they need to raise €115 billion by June 2012.

Under pressure, the banks are already deleveraging, selling loan assets to reduce their risk ratio. While that puts them on better footing, it could also help push the European Union back over the edge into recession.

“The US banking system doesn’t face the same degree of capital crunch,” said Boston Consulting’s Dayal.

Yet US banks are not nearly as healthy as they should be, and still face a weak economy next year, analysts say.

Growth in corporate and consumer lending business is sluggish, and accounting gains related to bad-loan provisions could evaporate.

Quintanilla says US banks boosted profits in the past few years by holding back loan-loss provisions relative to real losses. In 2012, “with the economy slowing and the world economy slowing down because of Europe, that kind of earnings lever is not going to be there as much.”

Moreover, new post-crisis reforms, mostly under the Dodd-Frank law, are hitting formerly key sources of income: trading on their own accounts is curtailed, and lucrative fee-generating business, like debit and credit cards, are under tighter controls.

How US banks will cope is already clear: paring staff. Last week, Morgan Stanley announced it is cutting 1,600 workers from its 63,000 workforce. Citigroup and Bank of America had already declared layoffs of thousands of workers each.

“Half of the cost comes from people,” said Richard Bove of Rochdale Securities. “So if you’re going to have a cost control programme, you’re going to have to fire people.”

In Europe, when push comes to shove, Bove expects governments will pony up some of the capital the banks need. But also, under push-back from the banks, the Basel III capital standards and risk-capital definitions will be eroded.

“In my view Basel III is never going to come into existence because the European banks are screaming bloody murder about it.”

“While that battle is going on no one in the United States is going to adopt Basel III, and force the US banks to take capital standards which the Europeans refuse to meet,” he added.

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