Tougher Capital Rules for 8 Banks - Analyst Blog

Recently, the Federal Reserve Board, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency OCC finalized stricter borrowing rules for 8 most systemically significant U.S. banking organizations. The tougher rules require the banks to be dependent more on equity capital than on debt and riskier assets.

Since the financial crisis, regulators have been contemplating several proactive measures to ensure that major U.S. banks strengthen their capital and liquidity levels to withstand another financial downturn.

A weak capital level is always a threat to the global economy. Needless to say, compliance with new rules would pave the restoration of a still shaky global economy, with fewer bank collapses and less involvement of taxpayers' money for the bailout of troubled financial institutions.

Finalized Rules

The rules direct bank holding companies (BHCs) with more than $700 billion in consolidated total assets or $10 trillion in assets under custody (covered BHCs) to maintain a Tier 1 capital leverage ratio of 5%. The new requirement exceeds the minimum leverage ratio of 3% recommended by international banking regulators as part of the Basel III standards. However, failure to achieve the requirement would restrain BHCs from discretionary bonus payments and capital deployment.

Additionally, the rules require insured depository institutions of covered BHCs to maintain a 6% supplementary leverage ratio to be considered as a "well capitalized" institution for prompt corrective action purposes. The rule, which takes into consideration off-balance sheet items such as derivatives and loan commitments, will be effective from Jan 1, 2018. Nevertheless, the banks will have to calculate and report the levels beginning 2015.

This rule will impact 8 most systemically significant U.S. banking organizations, which include Citigroup Inc. C, JPMorgan Chase & Co. JPM, Bank of America Corporation BAC, The Bank of New York Mellon Corporation BK, The Goldman Sachs Group, Inc. GS, Morgan Stanley MS, State Street Corporation STT and Wells Fargo & Company WFC. As per an assessment by the Fed, in aggregate, these banks will have to raise roughly $68 billion to meet the new regulations while the shortfall for banking subsidiaries is nearly $95 billion.

A New Proposal

The regulators have come up with another proposal that will further strengthen the banks' balance sheet position. They issued a notice of proposed rulemaking (NPR) that will modify the manner in which the supplementary leverage ratio is being calculated. This would be in accordance with the new international standards under Basel III.

The proposed rule will be applicable to all banks that are required to meet 3% leverage ratio and not only the eight banks mentioned above. The proposed change requires  banks to calculate investment holdings using daily averages.

This new proposal is open for public comments through June 13.

Still a Long Way to Go

These rules might limit the flexibility of the banks with respect to investments and lending volumes. Moreover, such stringent capital rules may considerably slacken the pace of a worldwide economic recovery in the near term.

Overall, structural changes in the sector will continue to impair business expansion and investor confidence. Several dampening factors – asset-quality troubles, mortgage liabilities and tighter regulations – will decide the fate of the U.S. banks in the quarters ahead. However, conformity to the new capital regime will ensure long-term stability and security for the industry.

Notably, when the rules were proposed last year in July, many of these eight banks appeared to fulfill the required criteria. However, if the above proposal is finalized, the banks will likely have to increase those assets that will be considered under the leverage ratio calculation. This will expectedly compel the banks to hold more capital.

Though the improving performance by the banks seems already priced in and there remain significant concerns, the banking sector's performance in the coming quarters is not expected to disappoint investors.