Increased Bank Capital Requirements – Some Investors Love It, Some Hate It

On 9 December, the Federal Reserve (Fed) released a notice of proposed rule-making (NPR) that would require the largest U.S. banks to increase their capital levels even further. Specifically, this new capital requirement will be tied to a bank’s “systemic risk profile.” That’s a fancy way of saying the importance of the institution as measured by a number of factors including its interconnectedness with the financial system, size, complexity, cross-country activity (making it harder to resolve across multiple countries), and dependence on short-term wholesale funding (making it susceptible to a liquidity crisis if credit markets seize up).

Based on a calculation that I won’t go into here for your sake, firms will have to hold more capital: 1% to 4.5% of what is referred to as risk-weighted assets. As with the vast majority of new bank regulations, there is an elongated implementation period that is phased in beginning in 2016 and becoming fully applicable in 2019.

The Fed indicated the following banks would have been on the list using year-end 2013 data: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street, and Wells Fargo. These are likely very familiar to you since they were all recipients of TARP funding during the financial crisis.

Reaction from investors was mixed:

“Hurrah! Alright! More capital! I’m even safer now!” exclaimed fixed income investors.

“Are you kidding me? More capital? We’ll never earn our cost of capital!” bellowed equity investors.

The varied reactions from investors are something we’re quite familiar with by now – after more than five years of increasing regulation. Equity investors are increasingly frustrated with rules being put in place to potentially prevent the next financial crisis, while fixed income investors are increasingly comforted (for the most part) by rules that require banks to increase their capital levels, improve the quality of their liquidity, and further de-risk their balance sheets and business models.

However, despite the disapproval of equity investors, we believe the actual impact on these banks is quite limited. Based on numbers we have seen from the Fed, almost all of the institutions on the list are already in excess of their requirements, including the fully implemented new requirement. Still, if you’re a fixed income investor, you’ve got to be a little happier!

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