Today the Senate and House meet to hammer out terms for the a final bill that is intended to address perceived weaknesses in bank regulation. Rest assured that some form of financial regulation reform will be enacted into law. Whatever the final content, FinReg will have broad impact on banking and credit for years to come.

(House Version; Senate Version)

Likely consequences of FinReg on the commercial banking sector will be:

• Reset of equity returns. Increased capital requirements and higher expenses will drive equity returns lower. My models indicate that most regional banks should expect equity returns to fall from a historical average of around 20% to under 14%, and maybe even lower.
• Bank consolidation. The net result of higher capital requirements and increased expenses necessary to comply with a heightened regulatory burden will be bank consolidation. I expect that most of the bank consolidation will occur in banks with asset ranges from $1 billion to $5 billion. This is the “middle market” of banking where there is sufficient critical mass to warrant sizable “cost out” plays.
• Re-evaluation of profit models. The full range of bank products are under attack. Mortgages, commercial lending, card interchange, and capital markets activities stand to become more heavily regulated, including price and contract terms. Banks are going to have to recognize and jettison marginal businesses and reduce the scope of products they manufacture.
• Opportunity for well capitalized, niche banking. Banks that can profitably manufacture products will are likely to expand their geographic footprints and / or offer those products on a wholesale basis.

In any case, for better or for worse, the US banking sector is about to fundamentally shift to a more concentrated system with much lower return expectations.

Two closing thoughts:

1. FinReg does not address a $500 billion hole in the Federal coffers known as Freddie and Fannie. This is just wrong and irresponsible on the part of Congress and the President.
2. From a macro perspective, we have an industry that is critical to U.S. prosperity (aka banking), where capital requirements and regulation are moving up, and earnings growth rates and equity returns are moving down. From a micro view, it looks like a market where consumer and small business credit will be more difficult to access and come at a higher price.

Does this sound like a recipe that will drive an economic recovery or reduce unemployment?

P.S. FinReg also includes a provision for a Federal Insurance Office under the Department of Treasury. Insurers of all types would be subject to their purview, with the exception of health insurance.