By James Saft
Nov 8 (Reuters) - Banking shares are down sharply since the election, but the threat of tough regulation now moving markets might hold a kernel of hope for investors.
The re-election of Barack Obama and the victory of several high-profile supporters of tough financial regulation - notably Massachusetts Senator-elect Elizabeth Warren - have cemented expectations of an increasingly difficult operating environment.
Although not far off 52-week highs, the KBW bank index is about 4 percent lower than just before the election. Morgan Stanley is 8 percent lower, while Citigroup Inc is down about 4 percent.
With Dodd-Frank legislation here to stay it may just be that the election forces banks to get serious about their and the industry's prospects. Banks, in short, might start to trim sails, getting out of unprofitable lines of business and even getting tough on compensation.
For an example look no further than Swiss bank UBS AG , which recently unveiled a root-and-branch restructuring of its investment bank, with 10,000 job losses and an exit from many areas of fixed income. UBS was perhaps the poster child for the unsuccessful universal bank, acquiring multiple businesses and paying hugely for talent over the years as it sought entry into areas in which it ultimately could not compete.
Markets absolutely loved the bank's new realism and UBS shares now stand more than 16 percent above where they were in late October before the announcement. UBS's decision was surely influenced by a much tougher attitude towards regulation by Swiss banking authorities, who have demanded much higher levels of capital.
"I suspect that many banks have not yet really understood what the consequences of the new capital rules for business will be when they come into full effect in 2019," UBS Chairman Axel Webber told Germany's Handelsblatt.
"We, on the other hand, see this new world very clearly. Besides that, Swiss rules commit us to even higher capital demands than the 10 percent capital quota that Basel III orders."
Had Romney won, many Wall Street executives would have said that tougher foreign regulation only represented an opportunity for U.S-based banks to gain global market share, a much less likely outcome today.
There are reasons to think that a smaller, less grandiose future will be very good for bank investors, if it comes.
Bank shares are not just cheap because of cyclical difficulties; they are cheap because investors, stung by intermittent scandals and extreme volatility in earnings, have imposed a sizable discount. Smaller banks and less risky banks may earn less on a return-on-equity basis, but could be able to obtain a better valuation on those lower, but safer, earnings.
In an industry in which employees take home up to half of revenues, the multi-decade boom in financial intermediation has tended to leave shareholders out in the cold, as banks compete for talent in what was for most a vain attempt to be a universal bank. As that reverses, look for compensation to drop, which will flatter the bottom line.
There is nothing the market likes better than certainty and trimmer banks in fewer lines of business, and with viable franchises, will produce more predictable profits. Higher profitability, helped by lower compensation, combined with less volatility should make investors willing to pay more for bank shares.
There are, obviously, huge risks to betting on this outcome. The first is that hoping bank executives become cautious stewards of shareholder money is akin to expecting turkeys to vote for Thanksgiving. It is not in their best interests and it involves accepting that rapidly expanding their firms was foolish or worse. No one likes paying themselves and their friends less and, at the same time, admitting they were either fools or knaves.
An investor's only protection here is leadership and knowing the board and top executives, how they think and where their bread is buttered is key. Do not expect JP Morgan under Jamie Dimon or Morgan Stanley under James Gorman to pull a UBS.
The second big risk is that, although we might believe that highly capitalized banks with safer profits are good investments, bank share prices might still have far to fall to get there.
The time to buy banks may not quite have come, but we are getting closer and it bears watching.