Will the Fed Mandate Capital Ratios for Investment Banks?

This weeks news that the Federal Reserve will likely be given a hand in the regulation of investment banks marks a new era for stand alone investment banking firms.  The agreement between the SEC and the Federal Reserve, once formalized by congress, will ensure that greater regulation of the financial markets occurs.  Whether this new bout of regulation will protect the economy from the fallout of a failure of another investment bank, increase general market transparency or encourages rampant risk taking is yet to be seen.  One thing though is certain, Goldman Sachs (GS), Lehman Brothers (LEH), Morgan Stanley (MS) and Merrill Lynch (MER) as the last significant remnants of a once highly fragmented industry will face considerable pressure over the next several years to revamp the way they support and run their businesses.  While it is too early to suggest that they will cease to exist as independent entities, it is reasonable to conclude that their business model will be significantly altered.   

If the Federal Reserve were to regulate the investment banks in the same manner that they regulate commercial banks significant restrictions would be placed on the firm’s capital and liquidity positions.  Government regulators would monitor the investment banking firm’s capital and liquidity position at all times, something I imagine the executives of the investment banks must just be dreading.  The regulators would, without a doubt, make it nearly impossible for these firms to carry out their business in a manner similar to the way they have operated over the last several decades.  Whether or not this is a good or bad thing is entirely too long of a discussion for this article but it is nevertheless something that should not stray too far from the back of our minds, as it has profound implications on the financial markets.  The investment banks by and large, with the exception of Goldman Sachs, have made every effort possible to prevent industry wide pro-transparency measures.  It is profoundly difficult to calculate the capital ratios for the investment banks.  While they may enjoy the allusion of invincibility that this gives them, it ensures that investors, analysts and regulators can only rely on rough calculations to construct a picture of the bank’s financial soundness.  In times of turmoil, such as last March, such a lack of transparency can result in failures similar to what occurred at Bear Stearns.

Any capital ratios imposed by the Federal Reserve would likely use the current ratios established for commercial banks as a base.  Currently the Federal Reserve requires that commercial banks in the United States have a tier one capital ratio, which is the most basic of the ratios used, to be in excess of 4%.  If the ratio is between 4% & 6%, the bank is considered to be “adequately capitalized”; however, if the ratio is above 6% the Federal Reserve deems the bank to be “well capitalized.”  While such a distinction may seem minor, it is actually incredibly important, as the Federal Reserve tends to prefer banks with ratios well in excess of 6%.  In my own personal experience, I have found banks with tier one capital ratios lower than 8% tend to be particularly nervous about the possibility of increased oversight by the Federal Reserve.  Such a policy helps to create a non-mandated but market preferred ratio.  Investment banks with their increased asset and liability volatility, continuous trading and thorough use of their own balance sheets will likely be required to have significantly higher capital ratios than their commercial bank brethren should the Federal Reserve win ultimate control over the capital and liquidity regulatory framework for investment banks.

While it is quite difficult to come up with the current tier one capital ratios for the investment banks, a guess can be made based on their quarterly and annual reports.  Of the four major U.S. investment banks only Goldman Sachs does a decent job of breaking out its capital ratio, the others tend to guard theirs intensely.  Based on my rough calculations Goldman Sachs has a tier one capital ratio of between 10.5% & 11%, Lehman a ratio of between 7.8% & 8.3%, Morgan Stanley a ratio of between 7.1% & 7.6% and Merrill Lynch a ratio somewhere between 7.75% and 8.25%.  As you can see, Morgan Stanley, Lehman and Merrill Lynch would all be of concern to Federal Reserve regulators, if they were commercial banks instead of investment banks.  However, given the Federal Reserve and SEC’s new cooperation agreement the Federal Reserve will likely up its pressure on the investment banks to raise more capital to shore up their capital ratios and strengthen their financial position.  The capital raises are likely to be significant as the firms are already in danger of falling below the “well capitalized” benchmark should the current streak of losses continue into the next several quarters.   The situation would become more perilous should the Federal Reserve mandate a minimum capital ratio for investment banks of in excess of 6%.  I would personally not be surprised to see a “well capitalized” ratio for investment banks of 8% and a “preferred ratio” of 10%.  Such a preferred ratio would force Lehman Brothers, Merrill Lynch and Morgan Stanley to go out and either raise tens of billions of dollars or to somehow become affiliated with a deposit based institution.  Regardless, the investment banks and the individuals who follow them are in for an interesting next 8-12 months.              

For Further Review:

Bloomberg Article on the Federal Reserve/SEC Agreement

Disclosure: None.