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Beware of Regulatory Setbacks for Banks


Government impediments in Australia could be the first of many on a global scale.

Editor's Note: This article was written by Minyan Ben Alcock. Ben studied finance in Australia. After traveling extensively, he began writing a blog and trading his own pairs trading system. His focus is working out new strategies for the current market environment and then putting them into actual practice.

With the Big Four banks being 99% (on average) off their lows and the three regional banks being 85%, the Australian banking sector has had a remarkable six months of performance. But -- and this is a big "but" -- I'm worried. I'm worried about the Big Four in Australia and I'm worried about major banking names across the world. And I'll tell you why.

Let's start with Down Under.

You may or may not have heard of the Aussie Government Wholesale Funding Guarantee, which basically lets the banks use the government's credit rating to borrow funds, while charging the banks for the service and adding to the coffers of taxpayers. The amount charged depends on the credit strength of the individual banks.

The Big Four have been able to keep their wholesale cost of funds pretty cheap, but the smaller regionals, well, not so much. All of a sudden, market share swings heavily to the majors -- no surprises there. So, be long market share and short expensive wholesale funding, right? Seems simple, but no. Enter stage right: regulatory risk.

The rumors around the big end of Sydney are that regional banks are about to be put back on a level playing field, and the quickest and easiest way to do this is for the wholesale funding agreement to either disappear or be a one-size-fits-all. I think to begin with, it will be the latter.

On Tuesday, the Big Four and the Three Regionals were down 1.1% and up 1.8% respectively, and on Wednesday, they were up 1.8% and 4.9% respectively. Being a Pair's Trader, this divergence caught my eye. It seems the traders in Sydney are starting to price the government's intervention as a certainty.

Which gets me to thinking: Are the markets taking enough notice of potential regulatory setbacks to the banking industry? We know that there are loud whispers from Europe about compensation packages and bonus restrictions.

So how do we play this? One relatively riskless strategy is to identify the banks that stand the most to lose from regulatory risk, short them, and be long the rest. If the industry booms or flops, we're relatively protected. But be careful if the global financial crisis blows over quicker than expected. If banks are back making shareholders happy, we might find ourselves on the wrong end of both trades.

Happy trading.
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