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Two Years On, Reassessing The Cost Of Dodd-Frank For The Largest U.S. Banks

Publication date: 09-Aug-2012 11:36:29 EST

Although it has been two years since the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) was signed into law, many rules are still not in place or final (see "It's All In the Execution: The Dodd-Frank Act Two Years Later," published July 12, 2012, on RatingsDirect). Nevertheless, Standard & Poor's Ratings Services has updated its estimates of what the new regulations under the DFA might cost the eight U.S. large, complex banks--Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, PNC Financial Services, U.S. Bancorp, and Wells Fargo--which we believe will bear the brunt of the financial impact.

We published our first estimates in November 2010 (see "What Financial Reform Could Cost The Largest U.S. Banks," Nov. 2, 2010). At the time, we believed that the bulk of the new regulations would have taken effect within two years and would have an impact on bank results by 2012 or 2013. However, the regulators have yet to write many of the rules, and many of those that are final have transition periods for their implementation that are longer than we originally expected.

Considering what we know now about rules and regulations that have yet to be implemented, and based on our current forecasts for banks' capital and earnings, we don't believe the financial impact of regulatory reform will, in itself, affect our ratings on the eight large U.S. banks. However, proposed rules and regulations could change our assessments of banks' business or risk positions (as our criteria define them), which could ultimately lead to rating actions in isolated cases.

(Watch the related CreditMatters TV segment titled, "How Much Will Dodd-Frank End Up Costing The Largest U.S. Banks?", dated Aug. 9, 2012.)

We estimate that the DFA could reduce pretax earnings for the eight large, complex banks by a total of $22 billion to $34 billion annually--higher than our prior estimate of $19.5 billion to $26 billion (see table 1). The full impact of the regulations could mean a drop in pretax return on equity (ROE) of 250 basis points (bps) to 375 bps for the biggest banks (see table 2). Most of the higher estimate reflects our view that regulators could take a more strict interpretation of the Volcker Rule than we previously expected, which is likely to begin affecting results toward the end of 2013 or the beginning of 2014, as regulators implement the provisions.

Table 1

Updating The Estimated Impact Dodd-Frank Will Have On Aggregate Large Bank Earnings
(Bil. $)
Rule Prior estimate New estimate (loose interpretation of the Volcker Rule) New estimate (strict interpretation of the Volcker Rule) Already in earnings?
Durbin Amendment (limits on interchange fees) 4.5-5.0 5.4 5.4 Yes
Derivatives (regulating the over-the-counter swaps market) 5.5-6.0 4.5-5.0 4.5-5.0 No
Deposit insurance (a new risk-based calculation method for assessments) 3.5-4.0 9.0-11.0 9.0-11.0 Yes
Volcker Rule (limiting proprietary investments and trading) 3.5-4.0 2.0-3.0 8.0-10.0 No
Costs (higher regulatory and compliance expenses) 2.5-3.0 2.0-2.5 2.0-2.5 No
Total 19.5-26.0 22.9-26.9 28.9-33.9

If we exclude the impact of regulations already in place (such as the Durbin Amendment and the new calculation method for deposit insurance), we estimate the potential reduction in pretax earnings would be $8.5 billion to $17.5 billion, or 90 bps to 195 bps on a projected pretax return on revenue basis based on full-year 2012 forecasts. Based on our projections for the group, this would mean ROEs of 8.8%-9.8% at current capital levels.

For comparison, we project that these big banks will post a combined pretax ROE of about 11% and a pretax margin of 22% in 2012. Although projected pretax margins have improved somewhat from our last estimate, projected ROEs have declined, largely because of banks' higher capital levels. U.S. financial institutions have built capital since the recent crisis to repair balance sheets and to comply with stricter capital requirements coming under the Fed's proposed implementation of Basel III (see "For U.S. Banks, It's Finally Time For The Full Basel Rules," published June 18, 2012).

Table 2

Assessing The Impact Dodd-Frank Will Have On Return On Equity For The Largest Banks
Current run-rate Incremental impact (loose interpretation of Volcker) Incremental impact (strict interpretation of Volcker) Total impact
Standard & Poor's forecast aggregate 2012 pretax earnings (bil. $) 97.2 8.50-10.5 14.5-17.5 22.9-33.9
Common shareholders' equity (March 31, 2012) $907 bil. 90 bps-120 bps 150 bps-195 bps 250 bps-375 bps
Return on equity (%) 12.2 11.0-11.3 10.2-10.7

The Durbin Amendment's Interchange Fee Restrictions Are In Effect

Estimated aggregate annual impact: $5.4 billion

One of the few DFA regulations that has already had an impact on banks' earnings is the Durbin Amendment, which allows the Federal Reserve to limit interchange (or "swipe") fees that merchants pay to banks. Although the final regulation--which took effect in third-quarter 2011--is less strict than the proposal, we've raised our estimate of the negative annual revenue impact on the largest banks to $5.4 billion from our previous estimate of $4.5 billion to $5 billion because the amendment has had a bigger effect than we anticipated. The final rule capped interchange fees at approximately $0.22 per transaction (plus other adjustments), up from the initial $0.12 limit, which banks argued didn't allow them to cover their costs. The efforts that banks have made to mitigate the impact of the Durbin Amendment, including charging new account fees and raising existing account fees, have had varying degrees of success, in our view. (See "U.S. Banks Are Changing Their Strategies To Mitigate The Financial Impact Of The Durbin Amendment," published April 30, 2012.)

Still Unclear OTC Derivatives Regulations Will Probably Reduce Banks' Margins

Estimated aggregate annual impact: $4 billion to $4.5 billion

As U.S. banks' trading revenues have declined over the past two years, our estimate of the negative impact that over-the-counter (OTC) derivatives regulation will have on banks' top lines has declined to $4 billion to $4.5 billion from our initial estimate of $5.5 billion to $6 billion. The proposed regulation covers OTC swap markets, including reporting requirements, the establishment of swap execution facilities, and mandatory central clearing of OTC swaps. Our lower estimate is not the result of any easing of the proposed rule, but rather lower trading revenue. We calculated a 38% drop in overall trading revenues for the biggest U.S. banks from 2009 to 2011. Some of the decline was a result of the particularly weak second-half 2011 results amid uncertainties about the future of the eurozone. However, we don't believe the decline is entirely cyclical (see "The Weakness In Capital Markets Revenues Appears More Structural Than Cyclical," published July 2, 2012).

As we did when making our prior estimate, we simplified our analysis by assuming that the overall industry derives 35% of all trading revenues from derivatives products and that the business generates a 35% operating margin. Based on historical derivative transactions, we continue to assume that 97% of derivatives can remain in (or move to) bank subsidiaries and that a large portion of these transactions will move to a clearinghouse. We also assume that greater pricing transparency and margin requirements for the business that moves to clearinghouses will cut margins for that business in half, to about 16%-17%. However, we don't assume that the regulation will cause a significant change in derivatives volumes.

Big Banks Are Contributing More To The Deposit Insurance Fund

Estimated aggregate annual impact: $9 billion to $11 billion

The Federal Deposit Insurance Corp. (FDIC) has changed how it determines the amount that U.S. banks must contribute to rebuild its Deposit Insurance Fund (DIF). As of April 1, 2011, the FDIC has been assessing banks based on their average consolidated total assets less average tangible equity, versus the previous method that applied an assessment rate to the banks' domestic deposit base. Banks have already incorporated the higher costs associated with this new calculation into their results. The FDIC has said that it intended for a greater portion of the assessment to fall on large banks, which rely less on domestic deposits for funding, but for which the market has typically added a too-big-to-fail premium.

To measure the change, we calculated what the assessment would have been using the prior method, based solely on domestic deposits. We then calculated the banks' average consolidated total assets and then subtracted average tangible equity to arrive at the new assessment base. We updated the assessment rate to 23.7 bps to reflect the middle point of the range that the FDIC would assess large and highly complex institutions, and we arrived at the annual impact we estimate the new calculation method will have on the biggest banks until the DIF reaches 1.15%. Our new estimate is more than double our prior estimate of $3.5 billion to $4.0 billion and incorporates a higher assessment rate as well as bigger bank balance sheets, which have grown with deposit inflows over the past two years.

But the DFA also has mandated that the DIF reach a higher minimum designated reserve ratio--1.35%--by September 2020. The FDIC expects to propose a rule to increase the assessment on banks with consolidated assets greater than $10 billion to make up the funding gap. This higher assessment rate wouldn't need to take effect until the DIF meets its previous minimum reserve ratio of 1.15%, which the FDIC expects will happen sometime in 2018. Our estimated financial impact does not consider this eventual rate hike, but based on the DIF's current size, the total funding gap would amount to roughly $14 billion that the FDIC would ask the largest banks to make up. Rather than eliminate assessments once the DIF reaches a certain level, the FDIC has finalized a rule that will gradually reduce assessment rates in the future. We expect that FDIC assessments will be a relatively small but still meaningful cost for banks over the next several years.

How The Volcker Rule Is Interpreted Could Make A Big Difference

Estimated aggregate additional annual impact of a loose interpretation: $2 billion to $3 billion
Estimated aggregate annual impact of a strict interpretation: $8 billion to $10 billion

We've expanded our range of what the Volcker Rule could cost U.S. banks to $2 billion to $10 billion from our original estimate of $3.5 billion to $4 billion because we believe the final rule, depending on how it's written, could have a wide impact on bank revenues. Most big banks have sold or shuttered what they believe are their most obvious proprietary trading operations and have begun to reduce their investments in hedge funds and private equity vehicles. But the proposed Volcker Rule takes a wider view of what may constitute proprietary activities and could have a bigger impact on revenues, though it could change based on feedback received during the comment period. And we are increasingly doubtful that the rule will become final anytime soon, considering a recent deadline for its implementation passed without comment.

We based our initial estimates in November 2010 on our interpretation of the legislation, which focused on prohibiting proprietary trading in its most obvious forms. We estimated banks relied on proprietary trading for just 1%-4% of total revenue. We've lowered our projection by half based on our current assumption that 0.5%-2% of total revenue still comes from businesses that the new rules deem nonpermissible, meaning banks would have to eliminate this business.

Our strict interpretation of the Volcker Rule's impact assumes that the final law is similar to its proposed form. The proposal takes an unspecific but wide view of what constitutes proprietary trading. It would effectively eliminate much of banks' market-making activities and would likely substantially reduce bank trading revenues by limiting inventories and clamping down on hedges. To simplify our analysis, we assumed that banks would lose 50% of their total trading revenues under this rule, and we assumed a 25% operating margin for this business. Based on the varying feedback the Fed has received on its initial proposal, we believe the Fed could relax the rule somewhat from its current form. If that happens, our strict interpretation estimate is likely overstated and the cost for U.S. banks would probably fall between our loose and strict interpretation estimates.

The Collins Amendment Should Have Little Impact On Banks' Capital Ratios

The implementation of the Collins Amendment--which imposes more strict regulatory capital requirements on banks--is unlikely to lead to any rating actions on U.S. banks. Based on our estimates for earnings, dividends, and assets, capital ratios should remain in line with our current capital and earnings scores (see "U.S. Bank Ratings And Capital Ratios Should Hold Firm Under The Collins Amendment," published June 27, 2012). The amendment disqualifies certain securities, including trust preferred securities (TruPS) and cumulative perpetual preferred stock, from Tier 1 capital. (The Fed determined that these securities aren't able to absorb losses as effectively as other forms of Tier 1 capital.) Banks have already begun to redeem a portion of their higher-coupon TruPS, either with cash or lower-coupon funding, which should benefit net interest margins.

Regulatory Compliance Costs Will Weigh On Bottom Lines

Estimated aggregate annual impact: $2 billion to $2.5 billion

We continue to expect U.S. banks will face incremental costs to meet new reporting and compliance requirements under the DFA. Expenses will likely relate to technology upgrades and new hiring. We assumed expenses will rise by roughly 0.5% of 2011 revenues. Although this is a relatively small amount, it comes on top of any costs already in place as banks comply with new or expected rules. Moreover, the estimated impact has declined from our previous estimate, which we based on higher full-year 2009 revenues. We acknowledge that most banks are working to cut costs to better align expenses with lower expected revenues--the success of which is unclear.

Loan-Loss Provisions Are Still Declining, Offsetting Regulations' Impact On Earnings

When we estimated the financial impact of the DFA in 2010, we highlighted the significant benefit that declining loan-loss provisions (or credit leverage) could have on banks' earnings. Nearly two years later, provisions have declined significantly, and we project that they'll continue to fall through at least 2016. We expect that loan-loss provisions for the biggest banks will total roughly $42 billion in 2012, versus our $96 billion projection for 2010 ($93 billion actual). But at more than 3%, bank reserve ratios (reserves to gross loans) are still higher than they have been historically, which is probably appropriate considering the still weak economic outlook.

Our projection includes our expectation that banks will release a substantial amount of reserves in 2012. In fact, net charge-offs will probably exceed provisions for the next few years. And reserves ratios will likely drop to near the bottom of their average range at about 1.5% of loans over the next few years, depending on the economic recovery, which is typically a nadir for reserves in the credit cycle. Those reduced provisions will probably continue to cushion banks' bottom lines, but many of the regulatory costs are recurring, and the trend of reserve releases will eventually reverse as banks build up their reserves because of growing loan portfolios or the beginning of a new cycle of credit deterioration. That is, we do not expect positive operating leverage before 2016-2017.

Many Regulations Are Still In The Proposal Stage, So Our Estimate Of The Financial Impact Could Change

Although regulators have made some progress on rule writing for new regulations under the DFA, many that could have the most significant effects on banks have so far only been proposed or are preliminary, including the Volcker Rule. Until we gain more clarity on these rules, we base our estimates of the ultimate cost of regulatory reform on educated assumptions rather than hard facts.

Primary Credit Analyst:Matthew B Albrecht, CFA, New York (1) 212-438-1867;
Secondary Contact:Carmen Y Manoyan, New York (1) 212-438-6162;

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