A Decision of Capital Importance for Banks

Stocks are essentially unchanged this morning, with the Dow (DJINDICES: ^DJI  ) and the broader S&P 500 (SNPINDEX: ^GSPC  ) up 0.03% and 0.04%, respectively, at 9:56 a.m. EST.

Fiscal cliff watch
President Obama is back in the capital this morning, but once the dust has settled, I think it's likely he could just as well have seen the new year in from Hawaii. With five days left before January 1, the odds of legislators ramming a fiscal cliff package through both Houses are dwindling. Furthermore, as individuals and companies become increasingly resigned to this outcome, the Republicans have a greater incentive not to reach a last-minute agreement. Indeed, the closer we get to the U.S. Treasury reaching the limit of its borrowing capacity (which must be extended by Congress) -- expected to be some time in February -- the more leverage Republicans can obtain in fiscal cliff negotiations.

The micro view
Large-cap financials are capping a marvelous quarter and year, with returns of 5% and 26%, respectively -- the best performance among the 10 sectors of the S&P 500 over both time periods. However, some analysts are warning that the Fed may force large banks to raise additional capital next year in the form of unsecured debt at the holding company level, in order to bolster balance sheet strength and flexibility. Barclays, the investment bank, believes the Fed could require banks to achieve equity and unsecured debt equal to between 15% and 30% of total assets. Another broker, Morgan Stanley, estimates that top U.S. banks would need to raise hundreds of billions of dollars of unsecured debt in order to be compliant.

Capital Group, a top 10 shareholder in Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) and JPMorgan Chase (NYSE: JPM  ) has been lobbying against such a measure on the grounds that it would lower banks' profitability by increasing their funding cost. Unsecured debt is subordinated to senior debt, and therefore, investors require a higher interest rate to own it.

Still, there are a couple of reasons bank shareholders need not be too concerned. For one thing, after requiring swift action on capital-raising in the immediate aftermath of the credit crisis, the Fed is now more forgiving on this front -- witness its willingness to extend the deadline for starting to implement Basel III directives beyond January 1. In addition, it's not clear that banks' cost of funding would rise even if they were forced to raise contingent capital -- while this debt is more expensive, a stronger balance sheet lowers the bank's overall risk. 

To learn more about the most-talked-about bank out there, check out our in-depth company report on Bank of America. The report details Bank of America's prospects, including three reasons to buy and three reasons to sell. Just click here to get access.


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