2 Banks Set to Profit From a Basel III Regulatory Loophole

Increased government regulation is something any business rarely welcomes, but two of America's biggest banks may want to consider making at least a partial exception in the case of Basel III, the new international banking regulations in which both Citigroup (NYS: C) and JPMorgan Chase (NYS: JPM) stand to gain considerably from a recently discovered loophole.

Basel III for non-central bankers
Basel III is the third in the series of "Basel Accords," rules designed to increase the stability of the world's banking system and drafted by central bankers from the world's 10 biggest economies.

Built on the back of 1998's Basel I and 2004's Basel II accords, 2009's Basel III accords were written in the aftermath of the 2008 financial crisis and tries to improve the sector's ability to deal with financial and economic stress, improve risk management and transparency, and strengthen banks at the individual level to reduce the risk of systemwide shocks.

Among other things, Basel III mandates decreased leverage ratios and increased capital requirements, both of which make a bank less profitable and typically make Basel III an unwelcome visitor for bankers everywhere.

The bane of banks, the boon of investors
Federal Reserve Chairman Ben Bernanke announced recently that all U.S. banks will eventually be required to meet the requirements of Basel III. But the Financial Times is reporting that many of the country's biggest banks are taking some solace in a capital-requirement loophole that will allow them to "retire billions of dollars of high-interest debt securities" early.

The debt securities are known as "trups," which stands for "trust preferred securities." In the past few years, trups have been a boon to investors and a bane to banks, as many of these securities were issued when interest rates were high, before the crash. As interest rates have plummeted, banks have been stuck paying trups investors a premium on these old investments.

Now you pay it, now you don't
Like most debt securities, trups have a defined maturity date, and under normal circumstances the issuing bank would be required to pay the coupon until that date. But Basel III is allowing banks an unexpected early out. Trups contain a clause allowing banks to repay investors before the maturity date if said security's status under capital rules changes.

This is exactly what's happening now. Before Basel III, trups weren't considered Tier 1 capital. Under Basel III, they are. This simple reclassification of trups debt has the potential to save banks billions on interest payments.

According to the Financial Times, Citigroup alone holds nearly $10 billion in trups debt, while JPMorgan holds almost $15 billion. Both banks have already said they'll retire up to $16 billion in trups. Coupons on this old debt can pay as high as 7%. Analysts estimate that JPMorgan alone will save $642 million per year in interest payments by retiring its eligible trups debt.

JPMorgan analysts estimate as much as $30 billion in retireable Trups exists in the whole of the U.S. banking system. Retiring this debt could save banks a total of $2 billion per year in interest payments.

Brother, can you spare a revenue stream?
The looming Volcker Rule, which bans proprietary trading by banks, is certain to put a crimp in banks' ability to make money. The increased capital requirements and decreased leverage ratios required by Basel III will do the same.

There's even a bill in Congress that argues for a breakup of the country's six biggest banks: JPMorgan, Citigroup, Goldman Sachs (NYS: GS) , Bank of America (NYS: BAC) , Wells Fargo (NYS: WFC) , and Morgan Stanley.

In this era of increasing domestic regulation, international regulation, and a down economy, banks everywhere are scrambling to find new ways to make money. This Basel III loophole is unexpected relief from a very unexpected quarter -- i.e., regulators.

It will be worth keeping an eye on JPMorgan's and Citi's balance sheets and earnings reports in the next few quarters to see whether this this debt-relief gain materializes. One would think Goldman, B of A, Wells Fargo, and Morgan Stanley also have a lot to gain by retiring their eligible trups debt. Surely some of that $30 billion in trups debt must belong to them, and some of it might be retireable.

But if the country's six biggest banks aren't your cup of investing tea, check out this Motley Fool special free report. We tell you about some delightfully straightforward and profitable bank stocks any investor can get his or her head around, including one Warren Buffett would have loved in his earlier years. The report is called "The Stocks Only the Smartest Investors Are Buying." Take a minute and download your copy while it's still available

The article 2 Banks Set to Profit From a Basel III Regulatory Loophole originally appeared on Fool.com.

Fool contributor John Grgurichwould like to retire some of his own debt, but that's another story. Most importantly, let it be known that John owns no shares of any of the companies mentioned in this column. Follow John's dispatches from the bloody front lines of capitalism on Twitter, @TMFGrgurichThe Motley Fool owns shares of JPMorgan Chase, Citigroup, Wells Fargo, and Bank of America and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Goldman Sachs and Wells Fargo. The Motley Fool has a gripping disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Read Full Story