Renewed concerns about the state of the global banking industry have sent bank shares around the world plunging to financial crisis lows and unfortunately, there doesn't seem to be any relief on the horizon for bank investors.
Record low interest rates are the latest threat to the banking sector. As interest rates plunge to new depths, banks (which are already feeling the pressure from increasing regulation) are finding it harder to generate a sufficient return on equity as net interest margins contract even further. The net interest margin is the spread between what a bank receives in interest from borrowers and what it pays out to depositors in interest.
UK banks are also facing another upcoming headwind in the form of ring-fencing. This will see large banks such as Royal Bank of Scotland(LSE: RBS) and Barclays(LSE: BARC) separate their investment banks from retail operations, a move which is designed to protect retail depositors from investment banking risks. But according to research from the Financial Times, the investment arms of RBS and Barclays are still years away from being able to stand on their own two feet.
Research by the FT shows that RBS is still diverting more than £70bn a year from its retail operations to support riskier financial activities, including investment banking. This cash transfer is designed to help improve liquidity for the investment arm but under the ring-fencing rules, this will no longer be allowed. Instead, RBS will have to raise this cash on the open market, which will be challenging and expensive.
Barclays is facing a similar problem. While the bank claims its investment arm doesn't rely on customer deposit funding, last year management floated the idea of making the investment bank a subsidiary of the retail bank instead of a complete ring-fence. The idea behind this suggestion is that as a subsidiary, the investment bank would be able to raise cheaper finance.
So, it's reasonable to suggest that Barclays may face similar funding issues to RBS when ring-fencing comes into play.
A complex sector
Ring-fencing is designed to make banks stronger, and in the long-term, it's likely that this will be the case. RBS and Barclays' commercial and personal banking divisions are more profitable than their investment arms. Separating the two will create a more level playing field for investors and customers alike.
However, in the meantime with so many headwinds buffeting the banking industry, it's almost impossible for investors to correctly value and profit from bank stocks. With more regulation coming for UK banks in the form of ring-fencing, investors are facing even more uncertainty. If the investment banks attached to Barclays and RBS can't learn to stand and on their own feet before the ring-fencing rules are introduced, they could face a liquidity crunch, which as we saw in 2008 would be bad news for the entire global banking sector.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.