On July 27, leading regulatory bodies in the finance industry including the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) released a series of reform proposals. They are seeking public comments until November 30th, after which another vote must be conducted to finalize the plan. The implementation of the reform measures could take several years, potentially up until June 2028.
Under the new reform proposals, banks with assets exceeding $100 billion would be required to increase their capital reserves by around 16%. The capital requirements for the eight largest banks in the United States, including JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley, could see a surge of approximately 19%. Banks with assets between $100 billion and $250 billion would be required to boost their capital reserves by around 5%.
Ever since similar regulatory tightening news was unveiled in early June, analysts have pointed out that the stricter capital requirements, lowering the threshold from a minimum asset value of $250 billion to $100 billion, would include more regional banks. This implies that mid-sized banks such as Regions Financial Corp., KeyCorp, and Huntington Bancshares Inc. could face stringent requirements typically aimed at large lenders.
According to federal data up to the end of March, institutions with at least $100 billion in assets would encompass 36 large and mid-sized banks in the United States.
Furthermore, the proposal aims to close a regulatory loophole that emerged in 2019. This loophole allowed mid-sized banks with an asset value below $250 billion to exclude unrealized gains or losses on certain securities from their capital ratios. Previously, only large banks with assets above $250 billion had to do this. Experts argue that this loophole hid the deteriorating balance sheets of Silicon Valley banks prior to their bankruptcy in March.
Regulators also proposed changing the way banks calculate risk-weighted assets. They wish banks to use two different methods when calculating key components of certain capital ratios.
One method involves considering the general credit and market risk of a particular activity under current US standards. The other involves considering the operational risk and any credit value adjustments of the activity. When banks eventually calculate their capital ratios, they must use the method that results in a higher level of risk-weighted assets.
The consideration of the operational risk of an activity itself represents higher regulatory requirements for banks relying on investment banking transactions and wealth management business for fee income. Operational risk covers a broad category, including potential financial losses due to internal processes, personnel, system defects, or external cyber-attacks, and fee-based activities are also seen as operational risks.
Some critics believe that the above proposals might penalize banks that focus on fee income but provide relatively benign services. These critics claim it could especially hit financial institutions like Morgan Stanley and American Express, which have large wealth management businesses. However, top executives from both companies have stated in recent earnings calls that their capital levels are still far above the minimum requirements.
Moreover, the draft of the new regulatory rules, which spans over a thousand pages, is prepared to require regional banks to raise long-term debt to absorb potential losses, increase their financial buffers, and propose higher capital requirements for the residential mortgage loan portfolios of large US banks based on international standards.
On the operational level, given that banks with similar asset sizes might have fundamentally different business risk profiles, the exact amount of strict capital requirements will depend on the business itself. Large banks could respond by holding more capital, shifting assets towards less risky assets, charging higher service fees to offset the increase in capital needs, or entirely exiting some businesses.
Randal Quarles, Vice Chairman for Supervision at the Federal Reserve, recently stated that most banks already have enough capital to meet the new requirements. He pointed out that following the pandemic, the banking system may need additional capital to be more resilient. Quarles said, "We don't know how the system might be impacted in the future, as we saw with multiple regional banks failing since March."
Reports suggest that the largest banks in the US had hoped that regulators would offset the impact of increased capital by easing requirements elsewhere, arguing that their capital levels are already far above those needed in a crisis, a fact proven by stress test results. Some banks have threatened that if they are required to increase the total capital held for residential mortgage loans, they will further curb such loan activities when many small and medium-sized banks exit the field. Others have indicated that they may temporarily delay stock buybacks until the impact of the new rules is clarified. Some banks have said they might exit some higher-risk activities.
Industry organizations representing bank interests have argued that some of these new rules would raise customer prices and push more activities into the so-called shadow banking sector. The Financial Services Forum, representing the largest US banks, stated bluntly that raising capital requirements is unreasonable and that the additional demands would primarily burden businesses and borrowers, hindering economic growth at the wrong time.
Overall, the long-anticipated latest US reform proposals are closely related to the international standards of Basel III, an international reform initiative launched over a decade ago in response to the 2008 financial crisis. The aim is to enable banks around the world to measure the risk of their assets in a comparable and transparent way. The demand for reform has become more prominent following this year's banking crisis in Europe and America.
Wall Street's largest banks have reportedly been preparing for the new regulations. These rules could potentially wipe out the billions of dollars in excess capital that they have accumulated over the past decade and suppress shareholder returns over the coming years. Industry critics argue that requiring banks to hold more capital could harm the competitiveness of US banks against non-banking lenders and European rivals and slow US economic growth.
On Thursday, the industry benchmark KBW Bank Index (BKX) of the Philadelphia Stock Exchange turned down and closed down by 1.2% at midday, after having reached a high since March 10th the previous day. The KBW Nasdaq Regional Banking Index (KRX) also fell by 1.6%, after having risen over 4% to a high since March 9th the previous day.
Currently, these two indices have not recovered all the losses since the Silicon Valley bank collapse on March 8th, which sparked the industry crisis.
