Holy Déjà vu: Big Banks Dipping Back Into Sub-Prime-Lending Waters, Amid Regulatory Changes

Forget the fiscal cliff. For investors in bank stocks, the real action in Washington D.C. is the ongoing implementation of the Dodd-Frank Act and what the pending rules will mean for large banks' profitability and regulatory costs.

Leaving behind any hope of repealing Dodd-Frank -- as presidential hopeful Mitt Romney promised to do -- Wells Fargo (WFC), JP Morgan Chase (JPM) and other big banks are bracing themselves for dozens of new rules on capital standards, proprietary trading, systemic risk, mortgage reform and consumer protection. They're hoping in 2013 to extend price gains from this year of 39% for Citigroup (C), 26% for JPMorgan and 22% for Wells Fargo as seen in a stock chart.

WFC Chart

WFC data by YCharts

Indeed, the recovering economy and growing consumer confidence are encouraging banks to relax lending standards and explore new markets to boost profits. In November, Wells Fargo came under attack by consumer advocates who object to high-cost, short-term loans such as the company's "direct deposit advance service," which carries 270% annualized interest and an average 10-day repayment term, according to a letter from the Center for Responsible Lending and the National Consumer Law Center to the U.S. Office of the Comptroller of the Currency.

U.S. Bancorp (USB) and Regions Financial (RF) are also offering short-term, high-cost loans to customers via their bank accounts. At least one state, North Carolina, is looking into whether the product tricks customers into predatory loans. For the banks, one surmises, the payday-loan-like deals offer a way to boost profits. The better banks' profit margins are on the mend, but still not at historical levels.

WFC Return on Assets Chart

WFC Return on Assets data by YCharts

The further we get from the housing market collapse and financial crisis, the more likely it becomes that banks will push lending standards lower and take greater risk in hopes of boosting the bottom line. With risk comes potential reward, of course, but also potential losses.

In addition to higher-cost lending, banks are ramping back up home equity lines of credit, now that the housing market is bouncing back and prices are rising. Moody's Analytics predicts that in 2013, HELOC lending will rise 31 percent to $104 billion, after climbing 30 percent in 2012. It's one way to generate some asset growth in a lackluster ecocnony.

WFC Total Assets  Chart

WFC Total Assets data by YCharts

One development that could hamper the ability of financial institutions to extend themselves into new markets is the question of capital requirements. U.S. banking regulators are in the process of imposing tough new capital standards under the Dodd-Frank Act, as are international regulators through the Basel Committee. If regulators significantly boost the amount of capital banks must hold on their books that will limit their ability to deploy that capital and boost profits. Already, banks are grappling with lower income because of Dodd-Frank ordered limits on the amount they can charge for debit card use, or so-called "swipe fees". One estimate put the impact of swipe fees at $9 billion for the whole banking industry.

Another player to watch is the Consumer Financial Protection Bureau, a watchdog agency set up under the Dodd-Frank Act that has the potential to make life very hard for the big banks through investigations, new rules and even just the soapbox that Director Richard Cordray has on issues like fraud, predatory lending, consumer protection and mortgage practices. The more time that bank CEOs spend in the halls of Washington regulatory agencies and Capitol Hill, the less time they can spend wringing the last dollar out of the American consumer.

Katherine Reynolds Lewis, a contributing editor at YCharts, is a regular contributor to Fortune Magazine online. Her work has appeared in Bloomberg BusinessWeek, Money, MSN Money, New York Times and Slate. She earlier worked as a national correspondent for Newhouse News Service, Bloomberg News' Washington D.C. bureau and the Bond Buyer. She can be reached at editor@ycharts.com.

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