New Capital Rules Likely To Shrink U.S. Banks

by: Martin Lowy

The concept of required regulatory capital for U.S. banks, not only the required amount, is changing significantly. That was one of the clear messages at a bank regulatory conference that I attended recently. The result is going to be that banks will have to disclose when their internal models suggest that their capital may be inadequate in future stressful market conditions. And when they make such disclosures, their stock is likely to drop immediately. Stockholders will have little or no time to take action to protect themselves.

On November 22, 2011, the Fed issued a press release explaining what large banks would be required to do. Under this regime, 19 large banks will be required to stress test their capital against various economic scenarios. The formal requirements are referenced in the press release.

The Fed summarized its intentions as follows:

The aim of the annual capital plans . . . is to ensure that institutions have robust, forward-looking capital planning processes that account for their unique risks, and to help ensure that institutions have sufficient capital to continue operations throughout times of economic and financial stress. Institutions will be expected to have credible plans that show they have sufficient capital so that they can continue to lend to households and businesses, even under adverse conditions, and are well prepared to meet regulatory capital standards agreed to by the Basel Committee on Banking Supervision as they are implemented in the United States.

Experts practicing in the bank regulatory field are telling me that this will require banks to change the way they think about capital significantly and that it is likely to change their appetite for holding risk assets. This is because the banks will have to evaluate the adequacy of their capital under a variety of assumed economically stressful conditions. These will have to include a Fed-mandated set of conditions as well as a simulation of a repeat of the market shock of late 2008. The Fed will examine the process used by each bank to assure its adequacy.

If their capital would become inadequate under any of the assumed conditions, the banks would be required (1) to disclose that fact publicly, and (2) to present a plan to the Fed for how the bank would raise capital or reduce assets or change its business strategy to bring capital back into compliance in all the stress scenarios. Capital thus becomes a forward-looking concept that is related to a bank's business strategy and model, rather than a backward-looking concept related only to the last-reported static balance sheet.

At the present time, the new requirements apply fully only to 19 large U.S. banks: Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Citi (NYSE:C), Wells Fargo (NYSE:WFC), U.S. Bancorp (NYSE:USB), SunTrust (NYSE:STI), Morgan Stanley (NYSE:MS), and Goldman Sachs (NYSE:GS), MetLife (NYSE:MET), PNC Financial (NYSE:PNC), Bank of New York Mellon (NYSE:BK), State Street (NYSE:STT), BB&T (NYSE:BBT), Fifth Third (NASDAQ:FITB), Capital One (NYSE:COF), Regions Financial (NYSE:RF), American Express (NYSE:AXP), Keycorp. (NYSE:KEY), and Ally Financial (not publicly traded).

The change to forward-looking capital requirements is likely to drive many large banks to lower-risk strategies that involve less trading risks and less exposure to higher-yielding types of loans.

From a macro point of view, this less-risky banking system will go a long way toward eliminating the too-big-to-fail problem by making the largest banks almost too strong to fail-and that is the Fed's intention. For a discussion of the background of regulatory capital requirements and the Fed's current intentions, I recommend Fed Governor Tarullo's speech on November 9, 2011, that shortly preceded the release that I have been discussing.

What the new regime will mean for banks' role in the financial life of the nation is, in my view, unknown. But it is likely to make room for more non-bank lenders, such as closed end mutual funds like INVESCO Van Kampen Senior Income Trust (NYSE:VVR), ING Prime Rate Trust (NYSE:PPR), INVESCO VK Dynamic Credit Opportunities (NYSE:VTA), and Eaton Vance Floating Rate Income Trust (NYSE:EFT), all of which are discussed by George Spritzer on Seeking Alpha. It also may tend to make the rates at which such funds are able to lend more attractive.

One almost certain consequence of the new forward-looking capital regime is that large American banks, after three decades of significant balance sheet expansion, will have to moderate their growth or, in some cases, even shrink. I will discuss some of the other forces promoting shrinkage in another article quite soon.

Disclosure: I am long GS, JPM.