CreditSights, an independent credit-focused research company, has issued a giant two-part report on what’s coming for U.S. banks in 2012. Naturally, it’s credit-focused. Surprisingly, it’s also quite optimistic and suggests positive implications for jobs (in comparison to a more gloomy report also issued by JPMorgan Cazenove).

According to the report, we are entering a post-modernist phase for banking, and banks will need to adapt to lower leverage and lower margin opportunities. Their returns will fall to the the high single digit to mid-double digit range. Among other things, post modern banking activities will be about providing hedging products designed for risk mitigation. Think solutions.

Despite a difficult regulatory environment that will slow revenue growth, CreditSights analysts are feeling optimistic. They expect a slow resolution of the Eurozone crisis, driven by the ECB’s liquidity program, which they think will keep European banks liquid and return some normalcy to the markets. They also point out that the fundamentals of U.S. banks are vastly improved and that liquidity is now two to three times stronger than before the initial crisis. They also believe the risk-off environment will subside as Europe stabilizes, as trading volumes recover and as M&A rebounds. All have a positive implication for job creation.

But that doesn't mean that there are no obstacles to growth.

The U.S. political situation and growth concerns in Asia remain wild cards, and positive revenue momentum will be dampened by the Volcker Rule, high capital and liquidity requirements from Basel III, margin pressure related to curve flattening due to "Operation Twist" and continued low revenues from ECM and DCM due to stressed trading conditions. On top of all this, the earnings boost from credit quality improvement has largely played out.

Volcker Rule Issues

The Volcker Rule is due to take effect July 21, 2012. CreditSights says the rule could "further reduce capital deployed on trading desks" and that trading revenues could decline. However, it also points out that banking regulators have extended the comment period for the rule from January 13t to February 13, 2012, suggesting there’s been a lot of "push-back" from the industry.

The really big issue with the Volcker Rule, as specified, is that U.S. banks will only be able to generate fees from commissions and bid/ask spreads, not from the appreciation in value of their positions. Equally, they will not be permitted to pay traders based on the appreciation in value of financial positions, only on commissions and bid/ask spreads.

CreditSights points out that: “The 7th rule explicitly states that any trading inventory position which is to 'earn profits as a result of movements in the price of positions' would not be considered market making. As well, we sense traders could be reluctant and/or restricted from putting on positions in advance of an excepted move as this could be seen as proprietary.”

While this could clearly be disastrous for traders in the U.S., who have been used to making revenues and getting paid on the basis of appreciating financial positions – even while merely market making – it may prove a very great thing in Europe and Asia.

This is because, as we noted back in October, the Volcker Rule as drafted allows proprietary trading as long as it takes place outside the U.S. and doesn’t involve a U.S. company or its subsidiaries. The draft rule also applies only to any trade directly involving someone in the U.S. (even if they work for a non-U.S. bank). Any trades executed “wholly outside” the U.S. will be exempt. The implication is therefore that non-U.S. banks will move both their traders and back office staff out of the U.S. and into Europe or Asia.

Basel III and liquidity capital rules are going to be a big issue this year

Even though banks theoretically have seven years to meet Basel III requirements, CreditSights says those that aren’t on track to meet them by 1Q13 could face restrictions related to dividend increases and share repurchases. By the end of this year, therefore, U.S. banks will need fully phased in 7 percent tier 1 common capital, with additional SIFI buffers of 1 to 2.5 percent phased in over time. The good news is that most U.S. banks are on track to meet the new rules already. Citigroup, Morgan Stanley and Goldman Sachs have "above peer average regulatory capital measures."

Merrill Lynch would be far better off without BofA

Finally, as a wild card, CreditSights analysts suggest Merrill Lynch bankers would do well to escape the clutches of BofA. “Mortgage concerns, credit losses and ill-timed acquisitions are all creating problems for Bank of America, leaving it in a ‘challenging position’ to meet the higher Dodd Frank and Basel III capital requirements,” they write. By comparison, CreditSights says Merrill Lynch is a "superior return opportunity," considering its “standalone comparables and business profile.”