For banks, the cost of new regulations is high:

Higher Capital Requirements

  • Standardization of risk-weighted asset floors has been proposed for Basel IV, following a similar approach to minimum capital ratios as in Dodd-Frank.

  • Total Loss Absorbing Capacity (TLAC) is expected to require systemically important banks to raise incremental long-term debt by 2019.

  • The Basel Committee expects its fundamental review of trading book (FRTB) regulation, effective 2019, will increase average trading book capital requirements by about 40%.

Higher Loss Provisioning

  • Expected loss accounting will be incorporated into IFRS Standards in 2018 and into U.S. generally accepted accounting principles (GAAP) by 2020, providing further motivation to dispose of non-pristine banking book assets.

Higher Compliance Costs

  • The Consumer Financial Protection Bureau (CFPB), created by Dodd-Frank in 2010, now employs more than 1,600 employees and has levied fines and consumer relief of more than $11 billion for unfair marketing of financial products.

  • The Bureau’s Qualified Mortgage and Integrated Mortgage Disclosure Rules impose greater potential liability on lenders.

Secular Investment Opportunities: Three Areas

1. Specific Funding Gaps

With quantitative easing designed to encourage the supply of credit and some $15 trillion in debt trading at negative yields, it is paradoxical that specific funding gaps persist. However, U.S. and European banks have retrenched from multiple business lines considered non-core. In the U.S. and UK markets, many banks have stepped back from originating non-conforming mortgages due to heightened scrutiny, increased potential liability and tens of billions of dollars in fines in recent years. Mortgage credit has tightened so much, in fact, that PIMCO estimates between 1 million and 1.4 million U.S. citizens who would have been eligible for a mortgage in 2002 (well before the loosening of lending standards that caused the subprime crisis) couldn’t get a mortgage today.

Originating mortgage loans to even a subset of these borrowers represents a scalable opportunity to lend at historically wide credit spreads, yet with conservative lending standards. This dynamic epitomizes a true funding gap, one where banks have genuinely retrenched, capital markets are closed to securitization and private capital faces material barriers to entry. Furthermore, a number of factors, alone or together, could result in much tighter spreads and upside convexity. These include consolidation among non-bank lenders, shifts in policy and regulations or the rehabilitation of the securitization market.