Investors get new reasons why not to buy bank stocks

Another new round of banking regulations likely will give investors yet another reason to stay away from the battered industry.

Federal Reserve Governor Daniel Tarullo this week announced that future stress tests will be geared toward demanding even higher cash buffers for big banks. The new rules, which won't take effect until 2017, will establish a "stress capital buffer" for stress tests that analysts say could raise capital requirements for large institutions by 3 or 4 percentage points.

Tarullo said the rules are guided by "the principle that financial regulation should be progressively more stringent for firms of greater importance, and thus potential risk, to the financial system."

Fed's Tarullo: Bank behavior hasn't changed enough

The upside for the industry is that banks with less than $250 billion in assets won't be subject to the same standards. But for the large Wall Street institutions, a regulatory backdrop that already was challenging just got a little tougher.

"Large banks are going to be forced to take on more capital. This will lower returns on capital," said Dick Bove, vice president of equity research at Rafferty Capital Markets. "It will make the cost of funding more, not less, expensive. It will reduce the appeal for investors to put money at risk in the banking system."

For investors, the most immediate effects will be in lower dividend payouts and share buybacks, tools critical for banks to keep their share prices afloat amid the tightening regulatory collar. In the first half of the year alone, financial institutions repurchased $52.4 billion worth of shares, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. In the second quarter, financials accounted for more than 20 percent of the total buybacks from companies.

Beset by pressure from regulators, an unexpectedly prolonged period of Fed-induced low interest rates and damaging headlines at Wells Fargo and Deutsche Bank, bank shares have been getting hammered.

The KBW Nasdaq Bank Index is off 3.7 percent in 2016, and financials as a whole are the second-worst performer on the S&P 500. The group was largely higher in Tuesday trading, but most of the big gainers were mid-size institutions like Regions Financial, Comerica and Zions Bancorporation that won't be affected by the new capital rules.

"Removal from the subjective portion, coupled with an expectation of a reduction in capital requirements, is a significant positive for regional banks," Edward Mills, financial policy analyst at FBR Capital Markets, said in a note to clients. "This should allow banks to have more certainty surrounding the process, have reduced regulatory expenses, and return more capital to shareholders."

That likely won't be the case for the banks that fall under the global systemically important financial institution, or G-SIFI, classification.

"This continued increase in capital is counter to the prevailing view that many of the covered banks are overcapitalized against current requirements," Mills said. "However, the higher standards could alter existing capital management plans at the G-SIFI banks or delay the narrative that banks will ultimately be freed to return more capital."

Daniel Tarullo
Andrew Harnik | AP

Bank investing has been a conundrum. At a time when the industry looks cheap — big banks are trading at 11.7 times earnings and regionals are at 13.1 times, according to Convergex — investors remain leery.

It hasn't helped that some of the biggest names have gotten caught in an unwelcome spotlight. Wells Fargo has come under increased pressure since a scandal over illegal sales practices erupted there, and shares are off 17.3 percent year-to-date, worst in the group among banks in the S&P 500. Deutsche Bank has been teetering and may need a bailout; its shares are off more than 50 percent.

Tarullo also indicated that the Fed is looking into implementing the standards on foreign banks operating in the United States.

"This could have negative future (i.e., 2018 or beyond) implications for the U.S. operations of major foreign banking institutions," Charles Peabody, analyst at Compass Point Research and Trading, said in a note.

The conundrum stirs up dark memories of times when the rest of the market was doing well but the financial sector was lagging.

"Why should U.S. equities overall be up 5-12 percent and banks stocks only flat on the year? Readers with long memories will remember other times when markets had skewed perceptions of financial stock valuations, either for good (2007) or bad (2000). Neither ended up working out especially well," Nick Colas, chief market strategist at Convergex, said in a note Tuesday. "I would argue that large cap financials either need to start working better, or the market overall has a problem."