The Federal Reserve Board and the Financial Stability Board, an international body that makes recommendations about the global financial system, have proposed new rules that would require eight of the biggest U.S. banks to increase their capital requirements. The main objective of these rules is to ensure the banking system is adequately capitalized to withstand a major recession such as occurred in 2008.
The Federal Reserve plans to incorporate surcharges into its annual stress tests to further improve capitalization of the nation’s biggest banks. Due to these changes, eight global systemically important banks in the U.S. will face a “significant increase” in capital targets, Fed Governor Daniel Tarullo said in a June 2 interview published on Bloomberg.com. The new capital requirements are expected to be formally proposed later this year, but likely would not take effect until 2018, according to a recent article in the Wall Street Journal.
Preventing bailouts
Regulators believe requiring large banks to prearrange passive capital would provide an important safeguard to the economy in the event of another recession and help prevent future taxpayer-subsidized bailouts.
“We need to have those eight most systemically important institutions more resilient than other banks in the economy,” Tarullo said in the Bloomberg.com interview. “You can have a smaller bank fail, and the economy can absorb it, but with the larger institutions, obviously there’s much more of a systemic risk.”
The eight U.S. banks that would be affected by the regulations are Morgan Stanley, Goldman Sachs, Citigroup, Bank of New York Mellon, JPMorgan Chase, Bank of America, Wells Fargo and State Street. These institutions would be required to meet a new long-term debt requirement and a new “total loss-absorbing capacity,” or TLAC, requirement, according to an Oct. 30, 2015 Federal Reserve news release. The requirements will bolster financial stability by improving the ability of banks covered by the rule to withstand financial stress and failure without imposing losses on taxpayers, the release said.
Morgan Stanley and Goldman Sachs would not be required to issue more debt since they already have substantial long-term debt on their books, according to a report from Moody’s Corporation.
Neal Blinde, executive vice president and treasurer for Wells Fargo, said during a May 2016 Investor Day conference call that the bank has increased long-term debt over the past couple of years in preparation of the need to maintain higher levels of TLAC. Wells Fargo’s long-term debt has increased from $97.2 billion in 2014 to $124.8 billion in the first quarter of 2016.
“We expect to meet the required minimums on Jan. 1, 2019, and Jan. 1, 2022, through measured issuance over the phase-in period,” Blinde said in a Wells Fargo summary of the conference call.
After the financial crisis, more stringent capital standards known as Basel III were enacted by global regulators. The Federal Reserve went a step further by requiring U.S. global systemically important banks to maintain additional capital of between 1% and 4.5% of assets. The Fed regulatory proposal would incorporate the additional surcharge into these banks’ annual stress tests.
Blinde said during the conference call that he believes Wells Fargo is in a strong capital position to meet the new requirements.
Return on equity
If enacted, these rules will significantly reduce these large banks’ return on equity, which could in turn dissuade potential bank investors, said John Barrickman, president of New Horizons Financial Group in Amelia Island, Fla., which consults with community banks.
Barrickman said the proposed rules will essentially force these big banks to slow their growth or potentially even shrink.
“This is the regulators’ real objective since they can’t force the big banks to break up,” he said. “They’re basically telling them if they want to stay big, they’re going to have to maintain more capital and internalize the risk to fail, with shareholders bearing this risk.”
The ironic thing is the regulations could result in these big banks engaging in riskier activities to maintain adequate ROE for investors, Barrickman said. “The rules could end up defeating the whole purpose in the first place, which is to make the system less risky,” Barrickman said.
Barrickman said another unintended consequence of the regulations will be less lending by the big banks. “If you have to maintain more capital, you’re going to have less money to lend,” he said.
As for timeframes for the new regulations, Tarullo said in the Bloomberg.com article the Fed’s changes probably won’t be implemented in time for stress tests in 2017 due to the multi-step rule process that must be followed.
Freelance writer Don Sadler contributed to the writing and research of this article.
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