European Union and U.S. regulators are debating the amount and under what circumstances banks should be forced to hold additional tier-one core capital reserves in excess of the law's requirement. The law requires banks to hold tier-one core capital reserves of 7 percent of risk-weighted assets. Regulators are suggesting banks be forced to hold tier-one core capital of up to 12 percent of risk-weighted assets.
A higher tier-one core capital-risk-weighted assets ratio means banks will have less money to lend. Less money to lend means the credit that is available is more expensive; consumers of lending pay a higher real interest rate. Higher real interest rates means less aggregate demand and less aggregate demand means less demand for labor.
Additionally, a higher tier-one core capital-risk-weighted assets means banks will make less money. As banks make less money there is pressure to create financial products that get around the regulations. Banks will innovate and create unregulated complex financial instruments that allow them to make more money. Banks make more money by taking risks and as banks take more risks the chances of them not being able to repay depositors increases.
The first people to be impacted by regulation that raises banks reserves is bank employees. Employees are paid less to cut cost and improve profitability. Employees can't take all of the pain, in addition to reducing employee compensation, banks will raise the interest rate they charge consumers. Both impacts of increasing bank reserves reduce aggregate demand.
Regulators in the European Union and U.S. are also trying to limit bonuses paid to bank employees. The impact of limiting bonuses is that people who would have gone into banking go into other fields; the labor market is distorted. Individuals that would have gone into banking now go into another highly-valued alternative for which they may not be as well suited and the economy is negatively impacted.
Also, revenue is going to be less than it otherwise would be. The decline in revenue growth means lower valuations for bank stocks. Lower valuation for bank stock means bank investors aren't as wealthy as they otherwise would be, and again the economy is negatively impacted. Net income is smaller than it otherwise would be and cash flow is also less than it otherwise would be.
By increasing the tier-one capital-risk weighted assets ratio regulators are providing banks with incentive to make riskier loans. As banks attempt to increase profit by making riskier loans, a bubble develops that poses substantial downside risks to the economy. As a bubble develops, inflation increases, and the Central Bank raises interest rates.
As interest rates increase, the cost of borrowing increases, and people become less willing to borrow. When people become less willing to borrow, the speculative bubble ends, and the economy contracts sharply. As the economy contracts sharply, people lose their jobs. When people lose their jobs, they aren't able to repay loans. When people aren't able to repay loans, banks face insolvency.
The regulators aren't solving the problem, they are the problem. Banks with large exposure to consumer lending in the U.S. are Well Fargo (WFC), JPMorgan Chase (JPM), U.S. Bancorp (USB) and Bank of America (BAC). Investors should be wary about investing in banks in general and these banks specifically.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.